Do You Really Understand Compound Interest?

According to genius Albert Einstein: “Compound interest is the eighth wonder of the world. He who understands it, earns it.” But thankfully you don’t have to be a genius to understand compound interest. And once you understand it, you can earn it!

Compound interest is basically the interest on interest. It’s also described as “the snowball effect.” We at Financial Aspects think it’s a beautiful thing. For example, lets say you invest $1,000 in a savings account for one year earning 5% per annum. By the end of the year you’ll have a balance of $1050 ($1,000 principal and $50 interest). Then you can reinvest that $1050 and by the end of the second year you’ll have $1102.50 ($1050 principal and $52.50 interest). That’s without you adding in more of your own money. Simply by letting the magic of compound interest do it’s job.

So what’s the different between “principal” and “interest”?

“Principal” refers to the original amount of money you invested of which interest is calculated from, that’s paid by your financial institution.

“Interest” is money paid regularly at a particular rate for the use of money lent, or for delaying the repayment of a debt.

“Compound interest” is the addition of interest to the principal sum of a loan or deposit, or as I mentioned earlier: interest on interest .

What’s the magic ingredient of compound interest?

In a word, time.

The earlier you start, the better.

For example, take a look at the images that accompany this blog post.

Over the course of 20 years, 60% of the total value of the investment after 20 years is the direct result of compound interest. And you’ll notice that those who start investing at 25, vs 35 experience the greatest growth. But if you’re no longer 25, please don’t despair, just choose to see the beauty of compound interest and use it for the greater good. If you have children, consider educating them on savings and compound interest (Kids love the invisible magic of making money).

If you’re unsure how you should be investing, call us to arrange a consultation. We can chat through your options and get you on the road to discovering the 8th wonder of the world.