“Compound interest is the most powerful force in the universe” – Albert Einstein
WHAT IS “INTEREST”?
When you place your money in the bank, you are actually giving the bank a loan – they have your money until you decide that you want them back. Since you are lending money to the bank, they need to compensate you for this. During the period where they hold your money, they will pay you something. That rate that they pay you is called “interest” or the “interest rate”.
Let us make up an example: assume that the bank will pay you an interest rate of 5% per year (you will often see “per year” written as “p.a.” or “per annum”), what does this mean?
If you want to place $100 in your bank account and your bank gives you a 5% interest rate per year, this means that one year after you have placed your $100 in the bank, you will have $105 in your bank account.
I calculated this by multiplying the initial $100 with 1.05. The number 1.05 is the same as (1+5%) and we remember that 5% is written as 0.05. This calculation is saying the following:
“Add 5% of the $100 to your existing $100”
THE “COMPOUND INTEREST” EFFECT
Now let me ask you a question:
If you decide to do nothing after 1 year with your 100$ that you originally put in the bank, how much money will you have on your bank account after the second year?
One might think that $110 is the right answer, but this is not true! Since you have $105 after the first year, you will get 5% interest rate of the $105. This means that we multiply $105 with 1.05 which gives $110.25 after year 2.
This might seem like a very little difference, who cares if we have $110 or $110.25?
THE LONG-TERM EFFECT SECURES YOU AND YOUR FAMILY
If someone ever tells you that you can make a lot of money in a short period of time, please do me a favour and run away. It is very few people who are lucky enough to make a lot of money in a short period of time. However, I want to state that it is not very hard to make a lot of money if you are patient!
Let me illustrate what I mean:
If we take the example from earlier where we deposit $100 in the bank and the bank offers you a 5% interest rate per year, how much money will we have in the bank after 10, 20, 50 years?
To get to these results we need to take the initial $100 and multiply with 1.05 for 10, 20 and 50 years.
Here are the results:
After 10 years: $163
After 20 years: $265
After 50 years: $1,147
Look how your money will grow and grow each year, we say that they grow “exponentially”. Imagine that you save some money every month and place them in your bank account and let them grow for many years. As you grow older, your bank account will have more and more money to support your own life and create a better life for your children.
As an investment advisor for many years, I have seen many examples of people who do not understand compound interest. If you decide to spend all your money today, you will not only lose the money you spend today, but also the money you could have had in the future from the “compound interest” effect.
Therefore I hope that you will have the following saying in mind next time you think about spending your money on something that is not very necessary.
“What you save today is a treasure for tomorrow” – Mrunal Pagnis
But this is slow process for those who dream big it can’t work!
Dear Nelly! Thank you for your comment. It is important to find a good balance between what benefits today and what benefits in the future. We hope you find our content educational in that respect!