Compound interest is a concept that comes with many labels. Some call it the secret to doubling your money. Some call it the ultimate set-and-forget investing strategy. Albert Einstein himself called it the 8th wonder of the world. But let’s call it what it really is: a regularly underutilised way of building your wealth.
“It feels so simple, it almost feels like it’s not true,” explains Brendan Doggett, Country Manager (Australia) of investing business Sharesies.
“But when you plug in some numbers, you look back like, ‘Really? $10… $10… $10… where do you get that?’ And it adds up.”
Here’s a quick ‘n’ easy breakdown of everything you need to know about compound interest from the man himself:
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What is compound interest?
The other quote from Einstein (allegedly) that helps explain it: “He who understands it, earns it. He who doesn’t, pays it.” Compound interest and the idea behind it is very easy to know when you’re paying it, like with a credit card (that’s interest on interest).
Benjamin Franklin also explains it pretty easily: “Compound interest is when money makes money. And that money then makes money. And then that money’s money makes money.” So it’s the good version of interest on your credit card.
As an example – and without getting into the math of all that – we’ve all been baking bread during lockdown. Compound interest is like your sourdough starter. You make it and it keeps growing and expanding and you don’t need to do anything else. That’s the non-financial way of describing it.
Another example people use when they talk about compound interest is the snowball. In the beginning, it starts off really slow, because the amounts are small, but over time, it gets to a massive amount.
Compound Interest Formula
- A = Final Amount
- P = Initial Principal
- r = Interest Rate
- n – Number of times interest applied per time period
- t = Number of time periods elapsed
The Rule of 72
The math behind compound interest is the Rule of 72. It’s all about how long it’d take for your money to double if you do nothing. If you divide 72 by the interest rate you’re getting, that’s how long it takes to double your money without you adding anything extra to it.
Compounding interest is one thing but if you invest in the share market you have access to compounding …….