A very famous and apt financial quote goes something like this:
"He who understands interest earns it. He who does not pays it."
Understanding the role compound interest will play in your financial future is the first step in truly taking control of your finances, of understanding the hidden and insidious wealth crushing power of debt, and in building confidence in the long term prospects of your investment portfolio.
The Basics of Compound Interest:
What is compound interest? Compound interest is a simple, yet extremely powerful financial force. Compound interest is interest that builds upon itself, resulting in compounding returns. Compounding returns can result in huge financial gains over time, when allowed to work undisturbed.
According to Dr. Jeremy Siegel's Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies, the long term Compound Annual Growth Rate (CAGR) of US Stocks has been approximately 10% a year over the last 200 years (before inflation, and including reinvested dividends).
Using the 10% benchmark in the chart below, you can see the extraordinary power of compounding returns in action. An initial $10,000 investment is worth $452,593 after 40 years of uninterrupted compounding growth.
Also take note of the extraordinary differential between the long term compounded returns with different interest rates.
This very simple chart shows how powerful the effects of compounding returns truly are in the long term investor's arsenal. These returns are not fictional, nor did I conjure this graph or the long term average 10% CAGR of the US stock market out of thin air. The graph is nothing more than simple mathematics, and the 10% CAGR of the stock market is based on exhaustive research by one of the world's leading economists, and author of Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies.
So how can you experience returns like in the chart above?
Understand Interest. He who understands interest earns it. Understanding interest will not only act as a catalyst to get you saving and investing for the future as soon as possible, but it will also become and incentive to keep yourself and your family out of debt.
He who doesn't understand interest pays it. When you are in debt, you are compounding your creditor's interest. That's right, the effects of compounding returns work in the favor of the financial and lending industries, so keeping out of debt is the first step to experiencing the long term benefits of compound interest.
Some Characteristics of Compound Interest:
It can work for you or against you. When you are in debt, compound interest works against you. If you are in debt, compounding returns has several resources to help you get out of debt as soon as possible.
When you invest, compound interest works in your favor.
It is the most powerful force in your investing arsenal. No one can guarantee market outperformance, but by purchasing a low cost index fund or ETF, you can keep your investing expenses low while at least guaranteeing you will experience the market average return, which has historically been 10% per year over all periods longer than 20 years.
Small amounts add up. Too many people believe that they don't have the money to invest. I believe these same people don't have the money not to.
Even a small amount invested monthly from a young age will result in incredible returns over time. Think about this: If your parents had invested $1 per day from the time you were born until your 18th birthday in a low cost Index ETF, and you never touched the investment account, by the time you were 60 years old, you would have over $1,000,000. That's a pretty decent return on $1 a day, which brings me to my final point...
Time is your ally. If you are lucky enough to have learned about compound interest when you are young enough to experience the full effects of long term compounding returns, congratulations! You are in a position to earn compound interest, and hopefully quit paying it to your creditors as soon as possible.
There are numerous financial resources available through web based sources, forums, and blogs like this one. Finding a community of like minded people is essential in the long term wealth building process.