“Compounding is mankind’s greatest invention because it allows for the reliable, systematic accumulation of wealth.” – Albert Einstein
Compound interest has been referred to as the 8th wonder of the world. Even Albert Einstein has referred to compound interest as man’s greatest invention. So, what is so great about it?
Let’s start out by defining compound interest. According to Investopedia:
Interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan or debt. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount.
If you have a savings account, you have experienced the phenomenon of compound interest. Let’s say you deposit $1000 into a savings account that gets 2% annual compound interest. After one year, you will have $10,000 (your principal investment) plus $200 (your 2% compound interest) for a total of $10,200. In the second year, you will get 2% interest on your new principal of $10,200. At the end of the second year, you will have $10,200 (principal) plus $204 (interest) for a total of $10,404. At the end of the third year, you will have $10,404 plus 208.08 for a total of $10,612.08. The growth will continue until your withdraw your funds, with your investment earning interest on both the principal and the interest it has earned in previous years.
Compound interest has the ability to grow your money over time in the context of savings or investment. But compound interest can work against you too. If you’ve even taken out a mortgage, used a credit card, or taken out a loan of any type, you’ve probably experienced the negative side of compound interest. Just as you earn interest on your interest in a savings or investment, you pay interest on your interest to a bank, lender, or creditor when you take a loan. This becomes especially important when you are dealing with large sums of money, such as mortgages, car notes, and credit card debt because a larger principal will equate to a larger amount of interest, compounding, that you need to pay off.
Investing wisely can make compound interest your greatest financial ally, but spending carelessly can make it your worst financial foe. Take Einstein’s advice and use “man’s greatest invention” as a tool to invest and spend wisely to maximize your compound interest earnings and minimize your debt.