If you're in the market to purchase a home, or if you are a small business owner, or you are looking to take out a small loan, or perhaps you are working on your retirement strategy, or starting a savings account, you have probably heard the term compound interest. And you are probably befuddled as to what compound interest actually is. Quite frankly, compound interest is indeed a complicated equation, but it can be explained, and you can learn how to leverage compounding interest in your favor.
A great way to think through how compounding interest works, and how you can make it work for you, is first by understanding the difference between simple interest and compound interest.
- Simple interest – This is calculated as P × r × n (use the same variable definitions as are later explained below). Simple interest is generally paid or received over a certain period and is a fixed percentage of the principal amount that was borrowed or lent.
- Compound interest – Calculated in the following paragraph, compound interest accrues and is added to the accumulated interest of previous periods; it includes interest on interest.
Compound interest is best explained as interest on interest. This formula shows you how to calculate compound interest, using the formula A = P (1 + r/n). You can then deduct the principal (P) from the result to get a figure for compound interest only.
For the above formula:
- A = the future value of the investment/ loan, inclusive of interest
- P = the principal investment amount
- r = the annual interest rate, in decimal form
- n = the number of times that interest is compounded per unit t (see below)
- t = the time the money is invested or borrowed
Warren Buffett, American philanthropist, entrepreneur, and Chairman and CEO of Berkshire Hathaway, known for his net worth of $84.4 billion, has gone on record multiple times to explain the concept of compound interest and how to make it work for you. He is one of the biggest proponents of compound interest.
Compound interest is often used in business transactions, investments, and financial products that are predetermined to last for numerous years. Simple interest is typically utulized for ones under a year.
This video from AK Fallible, released in just April 2019 is definitely worth a quick watch. The video starts with AK Fallible showing an example of what happens when he searches for the word beautiful on the internet. He sees images of several beautiful things, and in this case, sees the same beautiful person repeatedly. He uses this to help illustrate the benefit of compounding. The video goes on to share that 99% of Warren Buffett's wealth was earned after he turned 50 years of age. And even more interesting is that he has been investing since the age of 11. He actually used the money he earned in a paper route to buy farmland near his family estate. In high school, he got into the business of pinball machines (seriously), and by the age of 15, his net worth was $6,000. With an assumed inflation rate of 3.41%, that $6,000 would be $62,547.63 in 2019. Remember too that if he put that money into some sort of savings or investment fund, it was subject to interest too, and would be worth far more.
So, if you're not 11, and are more likely in your twenties or older, don't fret as clearly it is not too late. Buffett's net worth has grown exponentially over the last 30 years, and in fact, it more than doubled between the ages of 66 and 72, growing from $17B to $36B; in just five years!
You've probably heard the phrase, "it takes money to make money." With the stock market, you need to invest in stock first before you are going to make any money. If you are starting a business, you need to invest in the various equipment and intellectual property that is going to set you up as a differentiator in your niche market. And if you are looking to retire, you need to invest money into a retirement fund to get it to grow. Quite simply, the more money you invest, the more it will grow due to the compounded interest applied with each cycle. So, towards the end of your investment cycle, you will be making far more than you did when you started.
Going back to Buffett, it is interesting to note too that for such a wealthy individual, he leads quite a frugal lifestyle. He drives a modest car and still lives in the same home that he did back in the 1950s. But while he doesn't spend much money on himself, he is known for his generous philanthropy. Since the year 2000, Buffett has donated more than $46 billion. Philanthropy is what is important to Buffett, and he has created a lifestyle and business strategy focused on compounding interest, that allows him to donate to causes important to him.
With compound interest as your strategy to grow your wealth, know now that it is not a get rich quick scheme, and it will not happen overnight. So, if you need money fast, this is not going to help you. But, if you are patient and develop a savings strategy (20% of your net income is suggested) and stick to it, you will absolutely reap the benefits down the road.
