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A common goal for many people seeking financial independence is to create passive income, income that grows with minimal work involved. Compound interest is an essential factor in passively growing your money and can be a powerful tool for creating wealth.
What is compound interest?
Let’s start with simple interest first. Simple interest occurs when you earn interest on your principal (starting) amount of money only.
Where
- A is the total amount you will have at the end of your time period
- r is the annual interest rate
- t is the total number of years
- P is the principal amount you started with
In words:
Final amount = Principal + interest you accrued on starting principal over a set time
Example
Jeff starts out with a principal balance of $10,000. He is going to earn 4% interest on this amount for 15 years. This means that every year Jeff is going to earn 4% of $10,000. The first year he would earn $400, the second year Jeff would earn another $400, and so on.
Jeff’s simple interest formula would look like:
So, at the end of 15 years Jeff has accrued $6,000 in interest plus his initial $10,000 investment for a total of $16,000 at the end of 15 years.
Now let’s compare this with compound interest. Compound interest occurs when the interest you earn for a given period is then added to your original principal investment and you earn interest on your new, larger principal. Basically, the money you earned through interest is now making its own money… passive wealth generation.
Where
- A is the total amount you will have at the end of your time period
- r is the annual interest rate
- n is the number of times the interest compounds yearly
- t is the total number of years
- P is the principal amount you started with
In words:
Final amount = principal plus interest earned compounded at a set frequency of a certain number of years.
Example
Megan starts out with a principal balance of $10,000. She is going to earn 4% interest on this amount compounded monthly for 15 years. This means that every month Megan earns interest on her original investment and the next month earns interest on her new, larger sum. The first month Megan would earn $33 off of her original $10,000 investment. She would then get to add that $33 to her principal giving her a total of $10,033. The next month she would earn interest on the new principal of $10,033 and her principal would continue to grow.
Megan’s compound interest formula would look like:
At the end of 15 years Megan has accrued $18,203 in interest plus her initial $10,000 investment for a total of $18,203 at the end of 15 years.
This means with compound interest Megan has earned an additional $2,203 by doing absolutely nothing more than Jeff accept picking a better investment than him. Better yet, over 30 years Megan will have made over $13,000 more than Jeff.
The bad side of compound interest.
Just as compound interest can help you grow your money more rapidly, it can also cause your debt to compound more rapidly as well. Most credit card debt is compounded daily, which means that at the end of every day any debt amount you haven’t paid off grows. This is why it is imperative to tackle your debt as quickly as possible and do not just pay the minimum required balance.
How to use compound interest to your advantage.
- Start investing as soon as possible. Time is on your side when it comes to compound interest. Take care of your monthly expenses and debt paydown, but contribute what you can as soon as you can. Investment vehicles like low cost index funds, retirement accounts, and investment apps like Wealthfront can be great tools to begin your journey.
- Seek out investments with high annual percentage yield (APY) rates. The higher the average interest rate, the better off for your wallet. The more interest you are earning, the more money you will be able to add back to your original principal at the end of year period.
- Choose accounts that compound interest more frequently. Interest is typically compounded either daily, monthly, quarterly, or annually. The more often you are adding interest back to your original principal, the quicker your money will grow.
Summary
When choosing an investment, be sure to look at every aspect as a whole and not just each individual piece. This will help you choose the best investment for you. You can use this calculator to help decide. Once you financially able to start investing… START! Time is on your side when it comes to compound interest.
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