The Wonders of Compound Interest

Albert Einstein called compound interest “the greatest
invention of all time.” It has even been referred to as the
“Eighth Wonder of the World.” The trick is to get this
tremendous force working for you rather than against you.

Is compound interest gobbling up a significant chunk of your
earnings? If you maintain an ongoing balance with a credit
card company, compound interest is costing you much more
than you probably realize.

Let’s start with basic interest, which is a fee that you pay
to a lender for the privilege of borrowing his money. This
interest is attached to the original amount at an agreed
upon rate.

Compound interest is calculated on the balance owing plus
any previous interest charges. So then you find yourself
paying interest on the interest. This compounding effect
continues until it virtually takes on a life of its own.

Credit card lenders make a killing putting this principle to
work for them. Allow me to illustrate.

Let’s say you’re carrying a balance of $1,000 on a credit
card with a 15% APR. If you pay only the minimum each
month, you could conceivably gnaw away at this debt for over
25 years and end up repaying a total of over $3,400!

If, on the other hand, you could commit yourself to paying
$100 per month, this debt would be wiped out in less than a
single year and the interest would come to a much less
offensive $75.

Now let’s look at what would happen if you took $1,000 and
put it to work for you instead of against you. Let’s assume
that you are able to keep your hands off this money and
simply let it sit and earn 6% interest compounded annually.
After 12 years, your money would have doubled without you
adding one extra penny!

“Rule of 72”

You can quickly figure out in your head how long it will
take for a sum of money to double by applying the “Rule of
72.” You simply take whatever interest rate you’re earning
(6% in this case) and divide it into 72. The result will be
the number of years required to double your money. (72/6 =
12 in our example.)

You can apply the rule backwards as well. Let’s say you
have a lump sum of $5,000 that you would like to grow into
$10,000 in 8 years. You would need to find an investment
that pays 9% compound interest. (72/8 = 9). If the best you
can find is an 8% return on your money (hypothetically
speaking,) then it would take you 9 years to double your
money.

Not bad for just letting it sit there!

Now let’s assume that you want to help the growth rate
along, so you add an extra hundred dollars to this account
just once a year. At the end of the 12 years, you would now
have $3,800. If you could discipline yourself enough to add
$200 a year, then you would find yourself with almost $5600.

Seeing your money grow like this might well entice you to
invest more money each month and really reap the benefits of
this wealth-generating principle.

And there’s more good news. These examples demonstrate
what happens when your investment compounds annually. Some
institutions are more generous, compounding your interest
quarterly, monthly or even daily.

It’s pretty clear which end of the compound interest
principle you want to be on. The first step toward the
winners’ circle is to pay off your existing debts. Even if
you’re already having trouble making ends meet, a mere $1
addition to a minimum payment can significantly shorten the
life of that loan.

That’s right, just one dollar. You won’t miss it and it would
be well worth it. Remember the compounding effect.

And once you’re out of debt, there’s no minimum for earning
compound interest. Any sum that you can set aside will do.
You don’t need to be Donald Trump or Bill Gates in order to
benefit from compound interest. It can work wonders for us
all.