How Powerful Is Compound Interest?

Albert Einstein is rumored to have said “the most powerful force in the universe is compound interest”. That is an incredible statement for anyone to make, especially the Nobel Prize winning physicist who developed the theory of relativity! Obviously, compound interest is very important to understand, and even more so because it directly affects you nearly every day.

How Does It Work?

Compound interest is relatively easy to understand. The concept starts with the principle that you have money ($1,000) which is earning interest (10%) each year. So the first year, you earn $100 in interest. However, the next year, you do not earn another $100—you earn $110.

This is because your 10% interest is applied to both your initial principle and the interest you received. Thus, as time continues, your interest each year grows larger and larger because it is compounding on top of itself.

Returning to our earlier example, after a little more than 7 years, you will have earned $1,000 in interest—doubling your original investment without having to do anything. If you wait another 7 years, your balance will be over $3,750—a 250% return on your initial investment.

Compound interest is best explained visually. This chart continues our example of an initial deposit of $1,000 growing at 10% a year. As you can see, after 50 years the money has grown to just over $117,000—an unbelievable 11,639% total return on your $1,000, or roughly 233% average annual return.

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Make Compound Interest Work For You

The two most important factors for obtaining the benefit of compound interest are the interest rate and the length of time your money earns interest. The latter is the most important; your investment will grow slowly at first, but over the long term you will see dramatic improvements.

Since time is the most important factor of compound interest, you must not put off planning your investments or retirement—this is especially true for young people who are decades away from retirement. While 40 years is a long time, the best time to start saving and investing is now in order to let compound interest work for you. Over time, you can make compound interest work for you.

Silicon Valley Blogger points out how you can keep compounding interest working in your favor:

  • You make consistent contributions to your investments, thus continually growing your nest egg.
  • You live below your means.
  • You don’t get tempted into spending money as fast as it grows.
  • You don’t live in an area with an absurd cost of living.

Compound Interest’s Effect on Debt

It is important to remember that while compound interest is very powerful over the long term and can help you retire in style, it can also work against you. Interest works against you every time you take out a loan or have some sort of debt. The higher the interest rate, the faster the debt grows. Luckily, the effect isn’t quite as powerful if you are able to make payments on the loans, because the balance is decreasing.

Paying Down Your Mortgage Faster Can Be a Smart Move

While the negative effect may not be as powerful, interest expenses on debt can often add up to more than the value of the loan. For example, let’s assume you take out a typical 30-year mortgage for $150,000 at a 6% annual interest rate. By the end of the loan, you will have paid a total of $323,758.80—some quick math shows us that the interest paid on the loan was $173,758.80—more than the entire amount of the loan! It cannot be overstated how important it is to find the best interest rate on your loan in order to keep your interest expenses low.

Paying off your mortgage earlier may be a smart move. You’d be making what’s called  principal pre-payment. If you have a 30 year mortgage, you can save thousands by making extra payments. One of the best ways to keep yourself on the plan is automating your extra mortgage payment with your bank.

What Should You Do?

Be sure that you allow compound interest to work in your favor by saving now and investing for the long-term. If you keep focused on your goal of long-term financial security you can ensure a great financial future.

Guest Post Author: Jonathan is blogger who wants to help others get out of debt. He currently writes at Debt Loans.