Interest and Compounded Interest

I guess most people know what interest is and have a reasonable idea how it works. What I would like to discuss here is the power of compounded interest, that is, interest on top of interest because it is probably the most powerful force on your side when it comes to generating your wealth.

Compound interest, or interest upon interest, essentially means that you add the interest you earned back to the principal so that in the next time period you earn interest not only over your principal, but over the principals plus the previously earned interest. Doesn’t sound sexy, but if you have time on your side there is nothing better! Let’s have a look at a few graphs, which will illustrate both the importance of time and of interest or return when it comes to you investments.
 
Now, consider you have $10,000 dollars and
 
 

 

The rule of 72

The rule of 72, is a useful rule of thumb which states that the interest earned earned on your investments multiplied by the number of years required to double your investment equals 72, or to put it another way the number of years required to double your investment is to divide 72 by the interest earned on your investment.

For example, if you consider an investment that returns 6% per year you can estimate that it will take you 72 / 6 = 12 years to double your investment, alternatively if you earn 12% per year it will only take you 72 / 12 = 6 years to double your investment. Now, it’s a rule of thumb and therefore not 100% accurate, but I find it quite handy to keep in mind when your reading about potential investments and their expected returns.
 
To highlight how powerful compounding interest can be if time is on your side read this little bit of history from the Wikipedia entry for Compound Interest:

If the Native American tribe that accepted goods worth 60 guilders from the Dutch for the sale of Manhattan in 1626 had instead invested the money in a Dutch bank at a constant 6.5% interest, compounded annually, then in 2008 their investment would be worth over € 840 billion, more than the assessed value of the real estate in all five boroughs of New York City. With a 6.0% interest however, the value of their investment today would have been €140 billion - 6 times less!

Granted, none of us will live to be several hundred years old, but it shows that starting to save or invest early in life so that time is on your side will pay off.

Unfortunately, it’s not all that simple and rosy as I will now introduce you to your worst enemy, the one that will turns those billions from the Native American tribe into mere millions. No it’s not the taxman, nor is it your mother-in-law.

It's inflation.