When boiled down, there’s one single foundational piece of knowledge to understanding debt, and understanding investments.
Supposedly Albert Einstein said the most powerful force in the universe is compound interest. What did he mean? It means you don’t appreciate math as much as you should. Or at least one simple little formula you can plug into your phone or a free spreadsheet program.
It’s important enough that it needs to be spelled out so clearly that it’s burned into your memory. At least as clearly as your ability to remember the name of your own Mother.
Interest
Interest is a premium paid for loaning money from one person to another. You lend your best pal $15 Tuesday and next week he pays you back $15, the principal is returned, no interest paid. If he gives you back a $20 bill and insists you keep the difference, you just made interest from that loan.
Now technically speaking, you came out ahead on the money, and he ends up out of pocket. Fair trade? Maybe – depends on what he needed the $15 for and how much he needed it.
You buy an investment for $1000 at 7%, you’ve loaned a company $1000, and in return they’re promising to return the principle of $1000 with an extra $70 on top. If the $1000 was just sitting in your jacket pocket, it’s a good deal for you. Money for nothing.
If that company spends that $1000 to earn $1500, it’s a good deal for them too. If they earn only $500, not so good for them, but they still owe you that extra $70 at the end of the year.
Compound Interest
Instead of them giving you that interest in cash, they add it into the pot and give you a premium on the new total. Then again next year, then again, and again…
Lotta talk, but let’s take a look at some numbers.
The example to the right illustrates what $1000 you drop in an investment looks like if you
Compound Interest
let it sit there from age 30 to age 60. A one-time investment, looking at different interest rates compounding year over year… 1% probably doesn’t impress you much. 20% should make your eyes bulge. The 5-10% range is fairly very easy for a novice investors to get.
Most investment strategies don’t look like this.
Most people who collect a paycheck invest a little bit every month. A more useful example is to look at the difference that time makes. The classic example that financial institutions like to give is comparing two individuals who started investing the same yearly amount at the same rate but at different times and then showing what the totals look like over the course of their investing years.
For this example we’re looking at investing $1000 a year (which is a bit less than $3/day) at a rate of 5%. We picked
Compound Interest
5% out of thin air, but you can imagine what the difference would look like if the rate was higher.
Person on the left takes advantage of investing early to make the most out of the long time span. Starts at age 20, ends at age 29. $10,000 total invested.
Person on the right starts with $1000 a year at age 30, and every year following.
The person on the right doesn’t pull out in front of the person on the left until age 50. 21 years later, and $21,000 cash invested.
Person on the left increases their original investment 4X by age 52. Person on the right manages to increase their original investment by 2X by age 54.
The lesson you should learn from this is that compound interest favors the young, and those with long lives.
A good investment choice now beats a great one made later. So start now.
If you want to start plugging in your own numbers, go here.
For building wealth, compound interest is your most powerful tool. Make sure you understand it first.
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