How Does Compound Interest WorkHow does compound interest work? Ahhh, Great question my friend. This is one of the most important lessons for you to learn. “Why?” you ask. Well, in this lesson lies financial freedom or destruction. It all depends on how you decide to act in relation to compound interest. It has been said that "Those who understand compound interest are destined to collect it. Those who don't are doomed to pay it." How true, how true! So, by taking a little bit of time to learn how it works, you are putting yourself in position to be on the receiving end of the table. Doesn’t that sound like a much better deal?
Let's First Understand Simple InterestSimply put (no pun intended :) ), Simple interest means you only earn interest on the initial amount invested or borrowed.Let’s say you’ve got $1,000 and you want to invest it. It just so happens that your good friend Dani, needs $1,000 for a down payment on a car. Dani says to you “I will give you 10% on that $1,000, paid yearly with simple interest”. Let’s take a look at what that means. You give Dani the 1,000 bucks. One year from now the 10% is calculated on the 1,000 bucks netting you a profit (in interest) for $100. At the end of year one, Dani still cannot pay the money back. “No problem” you think to yourself, “I’ll just charge another year’s worth of interest.” Now we’re on year 2. We get to the end of year 2 and it comes time to figure out how much interest Dani owes. Well, let’s see… She borrowed $1,000 so 10% on what she borrowed would be another $100 bucks. So far, after 2 years, you’ve made $200. Let’s say this continues on for 10 years. So, at the end of every year, you calculate a 10% return on $1,000. At the end of 10 years, how much would you have? Well, if Dani paid you back the initial amount you loaned her, you’d get the $1,000 back. Don’t forget the interest she owes you of $100 per year for 10 years. You’d now have $2,000. Great! How Does Compound Interest Work?Compound interest is when you earn interest on the principle AND whatever interest has accumulated.Let’s say that Dani is so thankful that you’re going to loan her the money that she says to you, “Look, I know that you could use this money for other things and so it’s very important that I give you a good return on your money. How about I pay you compound interest on the $1,000 you loaned me?” You say, “Great!” (Not necessarily realizing the big difference). At the end of year one, Dani sends you a note showing the interest you’ve earned on the $1,000. It’s $100 bucks. Now, wait… that’s the exact same as with simple interest, isn’t it? Not so fast… You notice that the new principle balance for year 2 is $1,100 dollars. That means that the interest she owes you from year 1 is being put into the principle balance for year 2. You think to yourself “interesting”, and go on living your happy life. At the end of year two you get another note from Dani. This note shows that the interest from year 2 is $110, which surprises you. You call Dani immediately and say “Dani, I think you overpaid me on the interest. I lent you $1,000 at 10% so you only owe me $100 interest for year 2.” Dani politely responds, “Oh, but you forgot. The interest from year 1 of $100 was added to the principle to make the balance $1,100 for year 2. 10% on $1,100 is $110.” “Oh”, you say to Dani. “So it’s right?” “Yup, it sure is”, she responds. “Thanks again for letting me borrow the money, I love my new car!” You now realize that the interest from each year is being put back into the principle balance which essentially means you will earn money, not just on the $1,000 you originally loaned her, but also from the interest that was created out of thin air. The main thing to remember is that there is one big difference between “simple” interest and “compound” interest. That is the definition of principle. In simple interest, the principle always remains the same. It’s the amount you originally loaned or borrowed. It never changes. Therefore the interest you earn is always the same amount. In compound interest, the principle balance always changes. It includes the amount you originally loaned or borrowed, plus the interest compounded back into that amount. So what’s the big difference? Well, let’s run the numbers and see.
How do I make Compound Interest work for me?You can use this knowledge in a number of ways to help your own financial situation.Don't let it be used against you
Once your debts are paid off, start using compound interest in your investment strategy.
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