As an investor or even a financially inclined person, one of the most important pieces of information for you to note is that the power of compound interest is second to none!
Despite how clearly obvious this piece of information might seem, it isn’t the most widely propagated/well emphasized in financial institutions as well as some schools across the country. However, if you are looking to create or build wealth through investment in multiple portfolios, harnessing the power of compound interest is one of the best ways to do so.
What is compound interest?
Now, under normal circumstances, when people are thinking of interest, they think of the extra money that is paid on loans. This type of interest could be rather discomforting because it means that you would have to give more money to your lender than you were initially given. However, it has come to be widely accepted in the financial world.
Thankfully, the compound interest we’re referring to here has nothing to do with things of that sort. To put it simply, compound interest is the interest paid on the summation of the principal and interest garnered in the previous investment cycle. This is a step further than simple interest which only pays you extra money on the initial principal you invested. For compound interest to exist, you must’ve invested for at least two consecutive investment cycles.
Even we’ll admit that that might be a bit difficult to wrap your head around. So, let’s see if we can break it down further.
The direct opposite of compound interest is simple interest. Simple interest merely provides extra money on the initial capital after each investment cycle. If you invest $100,000 and you’re supposed to get an interest of 20% every month, you’ll continuously get $20,000 every month. This will only change if you add more money to the initial $100,000.
However, with compound interest, after the first investment cycle, you’ll get $120,000. The second investment cycle will then bring you 20% of $120,000, not $100,000 and so on. Get it now?
The power inherent in compound interest
To put things in perspective, let’s use two broad examples. We’ll call them Mr. A and Mr. B.
Now, both of these individuals have $10,000 to invest in a firm, and their interest rate is 25% every month. If Mr. A chooses to use simple interest for two years, he’ll get $2,500 at the end of every month for two years. Assuming that by some stroke of luck, he can save it all, he’ll have $2,500 x 24 (months) in two years. This equals roughly $60,000. When added to the initial capital, he’ll have a total of $70,000.
If Mr. B, on the other hand, chooses to use compound interest on the same investment portfolio, at the end of the first month, he’ll get $12,500. At the end of the second month, he’ll get $12,500 plus 25% of $12,500. This would bring his total earning up to $15,625. In the third month, 25% would be added to $15,625 again, and his earnings would go on and on. After two years of compounding his interest, Mr. B would have gotten roughly $2.1m. This is worlds higher than the mere $70,000 Mr. A acquired from simple interest.
Now, it is not particularly feasible to find a firm that’ll give you 25% every month. However, the truth still remains that compound interest has the potential to change your entire financial story regardless of the rate your firm gives you. All you need to do is to be disciplined with your finances. Don’t withdraw your earnings with every chance you get, compound your way to financial freedom.