Albert Einstein famously stated “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
So, what is compounding or compound interest and how do we make sure we are earning it? The simplest way to understand compounding and compound interest is using a table.
If we look at the table, this helps us understand how we can earn money on our earned money. If we start with 10,000 and earn 8% interest after one year we will have 10,800 ($800 earned). If we leave that invested another year, we will now earn 8% on $10,800 = $11,664 ($864 earned). Again, we leave that invested one more year and earn 8% on $11,664 = $12,597.12 (933.13 earned). This is 3 years of compound interest and we would have earned a total of $2,597.12 on the original $10,000. Simple interest would have earned 24%, because of compounding, in just 3 years we’ve earned an additional 1.97%. The table above shows 10, 20, 30, 40 and 50 years of compound growth.
Through our initial sweat equity of 10,000 earned, our money starts to earn money on itself. We can see through the chart that the biggest considerations in earning compounding interest are time and the return or interest on our investments. The longer the time horizon the more our money works for us. The higher return on our investments, the more our money works for us as well. Understanding that to get a higher return, we must take on more risk in our investments, which exposes us to the opportunity to lose money. A 12% rate of return year over year would be an equivalent to a unicorn in the wild. 4-8% is a much more attainable rate of return.
The moral of the story: if we want a work optional lifestyle or a fruitful retirement, we must start investing early in order to let our money work for us long enough to replace our income.
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