FinanceMind
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building financial freedomCompound interest is often referred to as the 8th Wonder of the World. Compounding interest is simply a process of allowing your interest (or returns) to earn you even more interest.
A simple example below will illustrate the power of compound interest.
Example: Compound Interest
Assume you invest $10,000 into a fund and you get a fixed interest rate of 10% a year, every year. In the first scenario you withdraw all your interest, leaving only the principal behind. In the second scenario you reinvest all your interest, thus compounding your interest.
| Scenario 1 Withdraw Interest | Scenario 2 Compound Interest | |||
| Investment | Interest @ 10% | Investment | Interest @ 10% | |
| Year 1 | $10,000 | $1,000 | $10,000 | $1,000 |
| Year 2 | $10,000 | $1,000 | $11,000 | $1,100 |
| Year 3 | $10,000 | $1,000 | $12,100 | $1,210 |
| Year 4 | $10,000 | $1,000 | $13,310 | $1,331 |
| Year 5 | $10,000 | $1,000 | $14,641 | $1,464 |
| Total interest earned | $5,000 | $6,105 | ||
From the example above, by with compound interest, you earn $1,105 more in interest over 5 years.
At year 10, Scenario 1 will earn you $10,000 interest where as Scenario 2 with compound interest earns $15,937 in interest. This is an extra of $5,937.
At year 15, Scenario 1 will earn you $15,000 interest where as Scenario 2 with compound interest earns $26,770 in interest. This is an extra of $16,770.
Such is the power of compound interest. Amazing isn’t it? This is the why all financial advisors encourage you to start investing as early in your life as possible so you can let your investment compound over a many years. When you invest early, you have time on your side.
When you allow your investment returns to compound long enough, the returns on your investment may exceed your employment or business income. When it has reached this stage, you can retire and live on the cash flows of your investment.
As wonderful as it is, compound interest could also destroy your health. If you are a borrower of funds, you are charged an interest expense. If you do not pay off your debt but instead let it accumulate, then you will find yourself paying more and more interest.
One classic example is your credit card. If you are not careful and miss your payment deadlines, you will find that you will be charged interest on the outstanding interest + purchase. It is indeed expensive to miss a payment deadline and one of the ways to minimize credit card charges is never to miss a payment deadline.
In summary, compound interest is a wonderful advantage to the investors. Start investing early so you can allow more time for your investments to compound.