Albert Einstein once allegedly claimed compound interest as the “8th Wonder of the World.” Now, why was a world-renowned scientist and Nobel Prize winner so fascinated by what was happening in his bank account?
Compounding is the term used to describe the fact that a balance with a constant growth rate does not grow linearly over time, but rather increases exponentially! To visualize this, imagine the following scenario:
Investor A starts with $1,000 in her savings account earning 5% interest per year. After 1 year, she will be paid $50 in interest (5% x $1,000). Her bank account after 1 year will then have $1,050. If she does not take any money out, after another year, she will not earn $50, but $52.50! This is because she is paid 5% interest on her new balance of $1,050 (5% x $1,050).
If she does not take any money out of her account, after 5 years, Investor A will have $1,276.28. If her balance did not compound, or she spent the $50 every time she earned it, she would only have $1,250 or have earned $250. This approximately $25 difference may not seem like it warrants the title of the 8th Wonder of the World, but consider a longer investment horizon:
After 15 years, the compounded balance would be $2078.93 versus a non-compounded balance of $1,750. This difference only increases with time. After 30 years, the compounded balance would be $4,321.94, compared to the non-compounded balance of $2,500!
The full relationship can be visualized below:
Once one understands how powerful compound interest can be when used in their favor, it becomes clear that the same effect can be used against them. Consider the following scenario: Investor B wants a new flat-screen television to watch his favorite football team lose in heart-breaking fashion. He does not have the money on hand, so he takes out a personal loan from his local bank at a 5% interest rate. If after one year, he repaid his loan, he would owe $1,050 (5% x $1,000).
However, Investor B still does not have enough money to pay off his loan, so he defers payment for another year. After two years, he would now owe an additional $52.50, for a total of $1,102.50 (5% x $1,050). As can be seen, the same force that was exponentially growing Investor A’s savings balance is causing Investor B’s owed balance to rise exponentially.
Compounding is a powerful tool that helps many individuals achieve financial freedom, especially as it rewards those who begin to save and invest very early.
However, this same powerful force also keeps many individuals from growing their wealth as they are forced to pay off their growing loans.