The 8th Wonder of the World – Compound Interest

Mon, Mar 8, 2010

When you put money on a savingsaccount you receive interest. Usually banks will give you between 2 and 5 % interest on your hard-earned money. Apart from there being easy ways to make higher interest rates (which we won’t go into now), it is imperative that you understand the concept of compound interest. There is not a single other concept that has made more people into millionaires than compound interest!

Normal Interest

Let’s say we have a bank account with a bank that is giving us 4% interest. In today’s economy that would classify as a high interest rate. Furthermore, we have put $1.000,- into that account.

That means that after a year, we’ll be receiving interest over the initial amount. So we get 4% of $1000,- which equals to $40,-. This puts our account balance to $1040,- after a year.

Compounding Interest

In the second year we get 4% over the amount in our account again. But this time, we have $1.040,- in our account! The interest is not calculated over the original $1.000,- but over the new $1040,-. This means we will be getting 4% of $1.040,- which equals to $41,60.

Our account balance is now $1.081,60. An we are getting an extra $1,60 interest over the initial interest. That is what compound interest is, that extra $1,60 we get in the second year. And the third year we get 4% over $1.081,60!

The Snowball

Let’s say that you are very smart (smarter than me) and you start putting $50,- in a savingsaccount every month from your 18th birthday. That means you need to save $1,50 each day approximately and you will save $600,- each year! Everyone can save $1,50 each day and put it into a bank account.

I typed this into my calculator and … oh my god, after only 10 years you will have $7.203,66! You will have gotten $1.203,66 in interest alone and have saved a massive $6.000,-. Imagine what you could do with that money…

But wait … it gets better. After 20 years, you’ll have $17.866,85 of which $5.866,85 is pure interest. After 40 years of hard saving you will have a staggering $57.015,31 of which the majority of the money is interest; $33.015,31!

Making a Bigger Snowball

There are many ways in which you can get a higher interest rate on your money, in return for slightly higher risk. If you were to invest your money with an investment fund that would give you 10% interest on average over the years the result in 40 years would be … $ 265.555,53! Of that an amazing $241.555,53 is interest!

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