Einstein has repeatedly said that compound interest is the eighth wonder of the world.
While it may appear complicated, it’s actually a relatively simple concept that can accomplish extraordinary things over time.
What is compound interest?
Compound interest enables you to earn interest on interest which is accumulated over time.
Metaphorically speaking, it’s like planting a tree. When that tree grows, it produces seeds that allows you to plant other trees. Those trees will also grow and produce seeds of their own. So with enough time, you could turn one tree into an entire forest.
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Difference between compound and simple interest
When it comes to earning interest, or a return on your money there are two types of interest you could earn.
Compound interest enables you to earn interest when you invest a sum of money. But in addition to this interest, you’ll also earn interest on the interest you’ve earned.
With simple interest however, you’ll only earn interest on your original sum of money invested.
For instance, if you invest $10,000 into a savings account and earn 5% interest compounded annually, in the first year your interest earnings will be $500 (5% x $10,000). However, in the second year, your interest will be calculated based on the original amount you invested, plus the interest you earned in the first year – $10,500. In total over 3 years, you would have earned $1,576.25 in interest.
With simple interest, your interest earnings won’t increase year on year so you’ll continue earning just $500 over the 3 year period leaving you with $1500 in interest earnings.
Compound interest is a long-term investing strategy
The effect of compound interest becomes extremely powerful over a long timeframe as the amount of interest earned grows.
Warren Buffett is the epitome of someone who values long-term investing. He attributes the majority of his success to identifying good businesses and companies with strong fundamentals to buy and hold for the long-term.1 He then let the magic of compound interest work for him.
One thing that is important to remember is that investing in the beginning doesn’t reap many rewards. It isn’t until years later that you feel the true power of compound interest working for you.
Get started early
Because compound interest is generally most effective over a long timeframe, in order to truly see its potential, the earlier you start investing your money, the better. So it’s generally really not about how much you’re investing, but more about how much time you’re allowing your money to grow.
How you can earn compound interest
One way to earn compound interest is through a bank account. While this approach carries very little risk, it’s generally unlikely that your returns will be enough to outpace inflation so this is something to keep in mind.
Investing in your super is one of the most effective ways to potentially maximise the benefits of compound interest.
Time is on your side. The more you contribute to your super early on in life, the higher potential for that money to grow by the time you need it as a result of compound interest. Of course though, you need to bear in mind that you cannot access your super until you meet a condition of release.2 This includes reaching the legal age for retirement, among other things.
When you’re paid dividends from shares, you can withdraw that dividend as cash or you can reinvest it back into the issuing stock. This means you’re earning dividends on dividends, also known as compound interest.
Bottom line: When it comes to investing, compound interest and time are truly your best friends.