Compound interest – you need to understand this

Hundreds of millions of people live paycheck to paycheck being part of what seems to be an everlasting hamster wheel.

The key is to not trade your time for money but rather making your money work for you.

Earning money is one thing. Saving money is quite another. Keeping your wealth can seem like a challenge. And growing your wealth only for the few lucky ones. 

Growing your wealth simple means that your net worth grows at a faster rate than inflation over time. This makes you richer and wealthier.

Unless you are born rich, you have probably gone through all stages of concern mentioned above: Getting a job so you start earning an income. Getting used to the cost of living when you moved away from home, and after (hopefully not too long) starting saving money on a regular basis.

Next step is to keep your money. Warren Buffet is often quoted of these two rules: Rule no. 1 – never lose money. Rule no. 2 – Never forget rule no. 1.

Think about how hard you have worked for your savings. If you are able to save 10% of your income (which is by the way, much better than most people these days) how much time are those 10% actually worth? For the sake of argument let’s say that a month’s worth of work amount to 4 weeks of 40 hours = 160 hours per month. 10% percent of that is equal to 16 hours of work, or two full days of work. 

Let’s say that you saved 10% of your income in a given month and then you lost all those 10% to some internet Multi-level-marketing scam all most immediately. Did you just lose what amounts to 16 hours of work or is there more to it? 

Well, let’s take a closer look. What would it take to save the save amount of money again? Assuming that you are not able to take on more work or moonlight your way through life, you would have to work the same 160 hours as you did the previous month. Remember, since your savings rate last month was 10% it translates to you having expenses amounting to 90% of your income. In this new month guess what – you would probably have to spend the same amount again to cover your expenses. Sure, depending on your situation your budget can be more or less flexible. But you still have to pay for food, insurance utilities and oh don’t forget the mortgage. So how much is your 10% of savings actually worth with this perspective in mind? A whole lot more than just two days of work! 

On a side-note: The bestselling book that has made an amazing difference in many peoples lives Your Money or Your Life adds another layer to this – check out the chapter on how to calculate your real wage per hour. It is truly thought-provoking.

It is super important not to lose money. How do you not lose money? First step: Don’t make stupid mistakes with your hard-earned money. It deserves better. You deserve better.

Next step is to make sure that your money grows at a rate that is the same as or higher than inflation. This can be as simple as using CD’s in some cases or buying bonds or bond-based ETFs.

The challenge lies not in keeping your money. Basically, as long as you don’t make stupid choices and fall for any get rich quick scheme, you are good to go. 

What sets the rich apart from the rest of people the world is growing your wealth. Now to really understand how to prosper financially we need to understand something fundamental: The power law also known as compound interest.

As Einstein is often quoted as having said (even though is not really possible to verify for anyone): Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t, pays it.

Clearly, it’s important to understand the concept. And it’s really simple. 

Let’s say you have $10,000 in your bank account earning you 5% interest per year (this is just an example for the sake of simplicity). After year 1 your account statement will say $10,500. You have just earned yourself an extra an $500.

Now here’s where the magic happens. In year 2 you will earn interest not only on your original $10,000 but also on the $500 interest earned in year 1. This means you will earn an interest of $525 in year 2.

YearInitial amountReturnEnd-of-year balance
110.000 US$500 US$10.500 US$
210.500 US$525 US$11.025 US$
311.025 US$551 US$11.576 US$
411.576 US$579 US$12.155 US$
512.155 US$608 US$12.763 US$

By year 20 you will be earning $1,263 in interest. This is really a snowball rolling. 

Understanding how compound interest works puts you in a position where you can really take advantage of time passing by. It is the core of the concept of making your money work for you.

Now that we got the basics of compound interest down let’s take it a step further and see why this should really matter to you.

Stay tuned