Compound interest

How Does Compound Interest Work?

What is compound interest?

Compound interest refers to the continuous addition of interest to a principal sum. In other words, when reoccurring interest payments are reinvested into an initial sum it results in exponential growth. This is because each reinvested interest payment will be larger than the last. To clarify, compound interest simply occurs when there is interest on interest.

 

Simple Interest vs. Compound Interest

 

Why is the compounding effect so powerful?

The compounding effect is a remarkably powerful force in nature that can cause positive or negative outcomes. Therefore, properly utilizing this concept in your financials can be a huge wealth builder. The reason for the effect being so influential is because the results build on each other at an exponential rate.

 

Examples of the compounding effect.

  • Illnesses spreading– For this example, an illness starts with one person. The infected person interacts with five people and infects them. Later, the five newly infected people each interact and infect 5 other new people, resulting in 25 new people infected. This pattern repeats at an exponential rate until there are millions of people infected.
  • Rumors spreading– For this example, one person in a school creates a false rumor about a classmate named Jim and tells 3 people. Those 3 people then each spread the rumor to 3 new people. This repeats, leading to the whole school thinking and believing the rumor about Jim.
  • Population growth– For this example, A new animal species starts with 1,000 beings. Each animal finds a partner and has four babies. The next generation as a result will have 2,000 animals that also go on to find a partner and have four babies. The next generation has 4,000 as a result and this repeats until there are billions of this species around the world.
  • Stock market investing– For this example, a person invests $10,000 into an index fund that produces a %10 annual return with interest reinvested. Following the first year, the person will have $11,000. After the second year, the person will have $12,100. Finally, after 40 years the person will have accumulated $452,592.
  • Growing a business– For this example, the profit of a business in its first year is $100,000. The business decides to reinvest its profits which will lead to a %20 growth in profits for the next year. In the second year, the business will have earned $120,000 which they reinvest again leading to another %20 growth in profits for the next year. In the third year, the business will have earned $144,000. They continue this pattern for the next 40 years and end up earning $146,977,156 in profits.

 

How can I use compound interest to build wealth?

The easiest and most efficient way to start building your wealth using compound interest is by utilizing a 401k and investing into the general stock market with your dividends reinvested. The 401K allows you to commit a portion of your pre-taxed money to an account where it can grow exponentially over time. Investing diversly into the stock market through index funds will on average bring %10 annual returns which will compound. In addition, most employers match your contribution up to half of %6 of your salary. Employing this strategy is extremely passive because the money can be automatically deposited into the account every time you get paid. As a result, you will be able to capitalize on the magical compounding effect.

 

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