Compound interest is possibly the most important tool used to increase wealth. however, most people don’t know how to use it. For some, compound interest is the reason they never have to worry about money. for others, it’s the reason they’ll never get out of debt.
Those who understand it can apply this powerful force and accelerate their wealth. those who don’t get it will often let their debts grow unchecked.
Reading: Robinhood compound interest
I’m sure you’ve met someone in the past who always seemed to be in debt. maybe it was a credit card from a retail store or a monthly payment for a new vehicle. most people in these situations don’t understand this powerful concept.
One of the most amazing things about compound interest is that it doesn’t discriminate. if you are rich, compound interest can make you richer. if you are poor, compound interest can make you poorer. no matter what race, gender, ethnicity, or religion you are.
Anyone in the world can earn compound interest and it can change your life for better or worse depending on how you use it.
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what is compound interest?
The easiest way to understand compound interest is to think of the process involved in making a snowman. imagine going outside on a snowy day. As you begin to pack up a large snowball to make your snowman, you begin to roll the snowball across the ground.
at first, nothing seems to happen at all. It looks like you’re rolling this snowball for no reason at all!
However, you will quickly notice that as the ball rolls, it increases in size and weight at an exponential rate. once the snowball is larger, it has a larger surface area to collect more snow. a basketball-sized snowball may have taken 2 minutes to double in size, but the next doubling cycle will take less time. this is known as the snowball effect.
The same effect can occur with your wealth. When you start earning compound interest, the returns seem insignificant at first. As you allow your money to grow, the compounding effect becomes larger and larger, and the rate of growth accelerates.
It’s not about how much you have, but how long you allow that money to grow.
how does compound interest work?
When it comes to earning interest, you can earn simple interest or compound interest. With simple interest, you earn the same interest rate each year. With compound interest, you can earn interest on top of your interest.
Compounding interest allows you to earn a higher return each year. Although this change seems insignificant, the growth takes place over a long period of time. Using the snowball analogy, those early years are the packing of the snowball. growth is invisible to the naked eye.
Consider this. if you invested $10k and allowed it to grow for 25 years at a market rate of 7%, your money would have grown to $54k! now, imagine investing that same amount of money for only 5 years.
after 5 years, that same initial investment would have grown to just $14k. compound interest works best for those who give their investments time to grow!
Play around with different amounts using my favorite compound interest calculator to see the true power of compound interest.
One of the best parts of compound interest is the ability to increase your growth even faster by investing a little each month over time. Let’s say on top of your $10k initial investment, you add $100 monthly to the pot. in this case, your investment would have increased to $130k!
The main factor that matters here is how much time you spend, not how much. While both are important, having a great investment isn’t everything.
why the rich get richer
The rich understand the power of compound interest and have probably been applying it for years.
so… why do the rich keep getting richer?
It’s simply because they started investing their money and allowed that money to turn into more money over time. they understood the power of compound interest early on and had the patience to see it through.
despite what we would like to believe, more people get rich from hard work and patience than from inheritance. If you simply live off the interest or growth of your account without touching the principal (ie, your original investment), chances are you’ll never run out of money!
The number one skill you must have to get rich is patience. compound interest will not make you a millionaire overnight. Earning compound interest is as exciting as watching paint dry on a wall or grass grow on a lawn. however, it is crucial if you want to experience tremendous wealth growth over your lifetime.
Few people can become millionaires overnight. for the remaining 99%, it takes time, patience, and a regular contribution.
how compound interest can work against you
On the other side of the coin, compound interest can be your enemy. consider the credit card in your wallet. the debt on that credit card can accumulate in the same way as the interest on your investments.
Let’s say you have a $5,000 limit on your credit card and you made the unfortunate mistake of going over it. your interest rate on this card is 22% and you are making a payment of $100 per month.
First, how long will it take to pay off this card?
and second, how much did you pay in total in interest and principal?
Don’t worry, most people can’t answer this. sounds like something that would have been useful to learn in school, but the world just doesn’t work like that.
If you were paying off $5,000 debt with no interest at $100 per month, it would take only 50 months to pay off that debt. If you were paying off $5,000 to $100 a month in debt at 22% interest, it would take you 137 months to pay off that debt.
That’s how I found this out.
To answer the second question, you would pay $5,000 principal and $8,678 interest for a total of $13,678!
Would you rather roll a rock uphill or downhill? Earning compound interest is like rolling a rock down a hill. Paying off compounded debt is like rolling a rock uphill. As we said before, compound interest does not discriminate. it can be your best friend or your worst enemy.
how to earn compound interest
There are many ways to earn compound interest. some of these methods are better than others, as you will see in the examples.
1. bank account
While this is not the best way to earn compound interest, interest earned from a bank account is compound interest. With a savings, checking, money market, or certificate of deposit account, for example, you can earn compound interest.
The interest rates that banks pay are extremely low. According to ValuePenguin, the average interest rate on a savings account right now is just 0.05% in the US.
Leaving your money in the bank will not make you a millionaire. you need to invest that money to allow it to grow! in fact, an important factor to consider is inflation. On average, inflation is around 2% per year. That means if the average return on an investment is no more than 2%, you’re really losing money!
2. stock market
Investing in the stock market is one of the best ways to earn compound interest. If you’re interested in learning more, check out our beginner’s guide to investing in the stock market.
With the stock market, higher risk yields higher potential reward. Long-term stock market investors can expect an average annual return of 8-10%. It’s important to remember that you won’t see this kind of performance every year! this is the average performance experienced over a long period of time.
At a 10% return, you would double your money every 7.2 years. This is why compound interest is best achieved when started at a young age. a young person might experience more of these doubling cycles than an older person. that’s why it’s imperative that you start early.
Another way to earn compound interest is through dividends. Dividends are regular cash payments paid to shareholders. a company may decide to retain earnings or share earnings with shareholders in the form of dividend payments.
When you invest in dividend stocks, you have two options. the first option is to receive these dividends in cash and the second is to reinvest these dividends. Reinvesting your dividends allows you to earn more dividends because you now own more shares.
While this is not the same as earning interest, the concept is the same. you are receiving free money from your investments, which will allow you to earn even more free money.
3. real estate
Another common way people earn compound interest is by investing in real estate. If this type of investment interests you, check out our complete guide to real estate investing for beginners.
This is one of the ways you can earn compound interest through real estate. Consider an investor who sells property for a living. this is a type of real estate investor who buys property cheaply, fixes it up, and sells it for a profit.
In year 1, they invest $100,000 in real estate. they fix it and, after expenses, make a $15,000 profit on the upside. this investor obtained a return of 15%.
In year 2, they invest $115,000 in other real estate. they fix it and earn another 15% return, but this time it’s a $17,250 profit!
At a 15% annual return, you would double your money every 4.8 years. remember, riskier investments have a higher potential return and higher return investments will have a shorter doubling cycle.
passive real estate investments
One of the problems with investing in real estate is that it usually requires a large initial capital investment. If you’re looking to own a two-family home, be prepared to put down a down payment of $20,000 or more!
fundrise is a real estate investment platform that has found an interesting solution to this problem. Thanks to modern technology, people from all over the world can pool their money to invest in real estate projects. you can read our full fundrise review here.
There are a number of advantages to this. First of all, the minimum to get started is just $10, which makes the barriers to entry significantly lower. Second, you are investing in a diversified group of real estate and not just one property.
If you own a two-family home and one of the units becomes vacant, you have just lost 50% of your rental income from the property. If you and 1,000 other people collectively own 10,000 units of real estate worldwide, one vacancy won’t make a difference. that’s the beauty of diversification.
fundrise is a great investment option to earn compound interest!
Learn more about fundraising here!
When I was younger, I remember my father sitting with me and showing me a compound interest calculator. Unfortunately, not everyone is as lucky as I was to be exposed to this at a young age.
As mentioned above, the most important factor when it comes to earning compound interest is time. the more time you have, the more time you can allow your money to grow.
If you’re wondering when is the best time to start, the answer is now!