Ever hear the motto — “make your money work for you”? What does that really mean? Talking heads and personal finance books all may advise you of different strategies for making your money work — investing in stocks, bonds or buying real estate. But underlying all of these arguments is a simple concept: compound interest.
Understanding this concept is the foundation of financial freedom and success. And unfortunately, I don’t think many people fully get how powerful it is and they need to! So what exactly is compound interest?
It is math of growth on top of growth year after year. Exponential growth. And its magical!
The math behind it is simple: A $100 that earns 5% each year will become $105 in year 1. That $105 then works for you and grows again to $110.25 in year 2 and so on. In ten years, your initial $100 will be worth $260. And you’ll only ever have ponied up $100! You can let your imagination run wild with this calculator.
As you can see the math underlying this is important because it shows two variables critical for compound interest:
1.) the rate at which your money will grow (an interest rate, the rate of return you earn on stocks or the % value that your real estate goes up each year on average); and
2.) the length of time that it will grow.
The higher #1 and the longer #2, the better your result will be. There are nuances to what will impact #1: things like investment expenses, inflation and taxes all get in the way of you maximizing the rate at which your money can compound.
But by this point you can see where I’m going and why this is so relevant for your financial health. Quite simply: regardless of your goals or even in the absence of “goals” — the earlier you start to save, the more you save and the rate you earn will endow you with tremendous flexibility at some point.
Save an extra $100 a month for the next 15 years and earn 7% on average, you’ll be $32,000 better off then. Your saving might seem like small amounts and not worth the effort, but it is critical. The message here is it gives you flexibility and freedom to do the things you want in the future, so take advantage of it!
It is no wonder that even Einstein said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”