12 Feb The Power of Compound Interest
You may have heard of this thing called “compound interest” and how it is a great tool to build wealth over time. Is it really this powerful? YES it is! Whether people decide to invest in stocks, or mutual funds, or bonds, they are earning an “interest” or rate of return on their principal. We understand that the higher the interest rate is the bigger return we will earn from our investment, however it is less obvious that the interest rate is calculated at fixed period (annually or monthly or quarterly) and it is never really simple interest rate with fixed rate on the fixed amount every time. In reality the interest rate is called “compound” interest rate which means the interest is calculated not just on the origin principal but the new principal with the interest income from previous periods. This enables the return to be greater over time and grows not at a linear but an exponential growth. In order to illustrate the power of this compound effect, I used excel graphs below to show 3 scenarios of how much the money would grow over the span of 30 years using compound interest. There are 2 assumptions I am making here:
Assumptions:
- Initial investment of $1000
- The annual return rate of 7% (the S&P 500 index fund has been averaging about 9.8% since its inception in 1928)
- Scenario 1: $0 monthly saving
- Scenario 2: $100 monthly saving
- Scenario 3: $1000 monthly saving -> (millionaire scenario!!)
As you can see by combining periodic contribution/savings with compound interest the future value of your investment changes drastically. You can be a millionaire if you save $12,000 a year for 30 years with an annual interesting rate of 7%.
You can check out various compound interest rate calculations using moneychimp calculator:
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