Compound Interest: How It Works!
Updated: May 5, 2020
Defining compound interest, Investopedia states, “compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.” To explain further, here is an example to illuminate the subject. Let’s say Blayne invests $1,000 in the stock market at age 25. After investing for one year, Blayne returned 10% on his money, which brings his total to $1,100. After year two, earning another 10% return, Blayne’s investment account now has $1,210. This increase can easily be explained. During his second year, he not only received a 10% return on his initial principal of $1,000 but also a 10% on his interest from year one. If Blayne keeps this investment from the time he is 25, averaging a 10% return a year until he is 65, he will have $45,260 in his account just from investing $1,000.
The 3 Factors in Compound Interest
Let’s say Blayne decides to invest his $1,000 dollars at the age of 18 instead of 25. Although he is only investing seven years earlier, the overall returns are nearly double the $45,260 he would have gained if he would have invested at age 25!
2. Rate of Return
To change it up, let’s say Blayne only returns 8% a year. At first, this 2% value does not seem like a big deal. However, returns evolve to be drastic over a long period of time. This 2% less return a year cuts the $45,260 that he would have gained by earning a 10% yearly return in half.
3. Amount Invested
For our last example, let’s say Blayne at the age of 25 decides to invest $2,000 instead of $1,000 in the first example. From investing double the capital, Blayne received double the amount in his future value.
All in all, compound interest is the reason so many are wealthy in the world today. Compound interest is the reason Warren Buffett has a net worth of $83,000,000,000! The best way to build a nest egg large enough for retirement is to use the three factors in compound interest listed above. To conclude, one should invest as early as they can, as much as they can, and get the best return they can without risking too much.