So recently I was browsing through Reddit and it kind of amaze me that some people do not know how Compound Interest works. I think it’s something important that we should know as we experience it a lot in our lives.
Compound interest (or compounding interest) is interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan. – Investopedia.com
In layman terms, it basically means interest on interest. Let’s say you have 100 apples. Someone approaches you and tells you that they will give you an extra 10% of the apples you have everyday. So for the first day, they will give you 10 apples. Now you have 110 apples. For the second day, instead of 10 apples, they will give you 11 apples as it is 10% of the 110 apples you have. In a way, your money is working for you!!
Knowing the power of compound interest can help you, be it whether it is being used by you or against you.
The way the world works is that if someone were to gain something, someone or something will have to give it to them. If compound interest is being used against you, it means you are giving this power to whoever using compound interest on you.
Let’s take an example of you borrowing money from multiple people. Here are the interest rates they charge you and the amount you borrowed:
You might think that paying Person C first might save you more money. But in actuality paying Person B first will save you more money. This method of paying debt is widely known to be Debt Avalanche. Here’s an article to read up if you would like to know more about this!
Now you’re probably reading this because you wanna know how it can make you more money, and you are half right! The power of compound interest don’t necessarily make you more money per se, but it makes it easier for you to make money. Let’s take a look at the chart below:
Let’s compare Susan and Bill. They both invested the same amount of money. But the difference is that Susan only invested for 10 years from age 25 while Bill invested for 30 years from age 35. Susan invested earlier in her life and is utilising the power of compound interest. As a result, when they are both age 65, Susan retires with a bigger sum of money even though she did less effort.
This is a very simplified example. But you can see how compound interest can help you in making money!
There are many things in our life that utilises compound interest and it’s important to know when it is being used against us and when it is helping us. This can help us a lot in managing our personal finance!
“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Albert Einstein