We at needhelppayingbills, as well as many financial experts, are always surprised at the number of people who do seem to know what compound annual rate of return and/or interest is as well as the benefits to this concept. It is one of the keys to building wealth over the long term.
There was one pretty smart and successful guy, Albert Einstein, who said compound interest is the “Eighth Wonder of the World” as the concept is so powerful. Einstein put this up there with the Great Wall of China, Stonehenge, Statue of Zeus at Olympia, and other wonders. It is estimated that 30 to 50% of Americans do now know a few basic financial questions, much less what compound rate of return is.
I was fortunate enough in that my mom told me about it multiple times when I was a young teenager. Thank you mom. Using that bit of knowledge from her and the “bug” she placed in my ear, I researched it more (and specifically buying stocks), learned as much as I could, and ran with the concept of it and started investing when I was 16 or so. I bought a printer company called GENICOM, and that was my first true stock investment. I then want on to learn more about it, studied investments, and continued on that track…but maybe another post at a late date to expand on this.
Hopefully more schools will teach the basics of investment, concepts of money, etc., because as we have just reported the educational system is not working for the younger generation when it comes to understanding money as well as managing it. More youth (heck as young as 10 years old?) need to learn about investing, compounding interest, and not needing to “keep up with the Jones”. It is not about being showy or flashy…but living “simply”.
You may ask, why is compound interest such a “Wonder”…what is it all about? At its basic level, it is you take the interest or earnings you earn on an investment and you reinvest those funds year after year. This sounds pretty simple to say the least, so why is it so powerful? Well, we will show you.
Examples of compound growth
Lets say you have $100 to your name, and on March 1, 2018 you buy a tax-free municipal bond fund that is paying out 4% per year. Sounds simple enough. So what happens then?
To keep it simple, lets say the 4% dividend is paid out one time per year, on February 28, 2019. Compound interest means you take that $4 in dividends and you re-invest it, which will then increase the balance of your account. So on March 1, 2019 you now have $104 in the municipal bond fund account ($100 initial investment + $4 in interest).
Then the interest is paid out again on February 28, 2020, and this time instead of making $4 in interest, you make $4.16 in interest. You made a little more money in interest as your account balance was $104 on February 28, 2020, and that was the calculation used to determine the payment. In year two you therefore made $4.16 in interest rather than $4 like you did in year #1 as you continued to let the interest on the initial investment be re-invested.
At its core, that is what compound growth is. It is making your money work for you by reinvesting the gains. While all of this may not sound like much money or make a big difference (as what is an extra 16 cents!) the key is to let the money compound over the years.
Using that same $100 investment made on March $1, 2018, and using a 4% interest rate, compound rate of return will look like this.
This tells you that in 8 years your initial $100 investment is now worth $136.86. Your initial $100 investment worked for you and earned $36.86 for you…without you having to do a single thing. You could have sat on the couch and still made that extra money.
The effects of compound interest continue to build and the amounts grow even more over time. Or, if you were to invest a little more money and/or earn a slightly higher rate of return, then the results are even more impactful. Lets say you invested $1000 in March 1, 2018 at the 4% return, the results would look like this.
That is $368.57 your investment “earned” for you!
And if you invested $100 on March 1, 2018 and received 7% returns/interest per year (say a stock based investment instead of bonds) the results would be.
You therefore earned $71.82 as the result of compounding! And did not even need to lift a finger for that money. Now instead of $100 as an initial investment, you can use that as a baseline and multiply it by different amounts to determine how much you would have earned from compounding by a larger initial investment. For example, if you initially invested $1000, take that $100 multiple it times ten (and the $71.82 x 10 as well) and you would have earned $718.20 as the result of compounding interest.
No wonder that Einstein called compound interest the “Eighth Wonder of the World” as it can have such a powerful result, though the concept is so simple. The key to make it work is to save and invest as early as possible. Even if you are lower to moderate income, the key is save a little money each money, and let the interest, dividends, or capital gains continue to be re-invested year after year (compound) and let the balance grow.