Compound Interest: The Strongest Force in the Universe

Compound Interest: The Strongest Force in the Universe

Albert Einstein  and Warren Buffet are two men known as experts in different fields.   One thing they shared a love for was Compound Interest.  One famous Einstein quote is, "Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."  Buffet too is a huge fan of Compound Interest.  He once stated, "My wealth has come from a combination of living in America, some lucky genes, and compound interest."  In Einstein's case, he was explaining both the good and bad side of the same thing.

 

What is Compound Interest?

When you think of interest, it’s easy to associate the term with loans and credit cards. As it accrues, it’s usually money that comes from your pocket. But, interest isn’t always a bad thing!

 

Interest can be viewed as a reward for leaving your money with a financial institution. As money sits in an account, the interest you earned within a set period is added to your principal balance, and you begin earning interest not only on your initial investment but also interest on your interest.  This is known as compound interest.

 

Over a period of time, as the balance grows, the more you will earn.   For example if you invested $10,000 at 5% annually, after your first year you would earn $500 in interest and now have $10,500.  The next year you would once again earn $500 on your initial investment but this time you will also earn an extra $25 on the $500 in interest from the year before.  This $25 payment is called Compound Interest.

 

Below is an example explaining how compound interest works if you were to start with a one time investment of $10,000 at an annual interest rate of 5% percent:

 

Time Frame $10,000 Becomes Gain in Previous 5 Years Gain due to Compound Interest
in 5 Years $12,763 $2,763 $263
in 10 years $16,289 $3,496 $996
in 15 years $20,789 $4,500 $2,000
in 20 years $26,533 $5,744 $3,244
in 25 years $33,864 $7,331 $4,831

 

As you can see, the longer the money stays invested the more powerful and significant Compound Interest becomes.

 

Where Can I Earn Compound Interest?

 

Some banks offer savings programs, like Certificate of Deposits (CDs) and money market accounts where you can earn compound interest on the money you have set back at a very low risk.

  • Money Market: This type of savings accounts typically yield higher interest than the traditional types and generally require a higher minimum balance. Most money markets grant you a specific number of withdrawals per month, some even send checks or debit cards to take funds directly from the account. Some money market accounts may have a monthly fee.
  • Certificate of Deposit (CD): When you open a CD savings account, it works differently than a traditional savings or money market. A CD has a set date of deposit and a maturity date. You cannot continue to deposit into the account and you cannot withdrawal from it without penalty until the maturity date. Without a monthly fee, CD accounts allow your money to accrue interest with very little risk.

Both accounts are likely FDIC insured of up to $250,000.

 

If you’re willing to take some risk for a bigger reward, you can place your money in an investment like Bonds.  Bonds are similar to CDs in that you buy a certain amount and they pay you a prescribed amount of interest.  These typically earn  you more interest on your investment than with a bank  but unlike many bank type investments, they will not be insured unless they are US Government bills/bonds  or certain types of Municipal bonds.  Bonds typically have a risk rating assigned to them by independent third parties.

 

When you’re looking for an investment that can compound interest, it’s crucial to start early and keep in mind the risk you’re willing to take.