So You Wanna Be Rich: The Secret Behind Compound Interest
As adults, a lot of us have big dreams and aspirations when it comes things such as owning a home, driving a nice car, traveling around the world, etc. The media like to sells these ideas to us, but most of the time we find ourselves saying things such as, “If only my job paid more,” “If only I won the lottery next week,” “There is no way I could ever save enough to afford _____.” While these things would certainly help you achieve what you want, they are not the only solution! Most people, especially teenagers and young adults who are fantasizing about driving a Ferrari or owning a mansion, have a resource that is often undervalued, the resource of TIME. Now you might be thinking to yourself, everyone has TIME, why is time so important? It’s important because it is the factor that drives compound interest, a magical concept that people don’t take advantage of, and often do not understand.
Let’s look at the definition: The addition of interest to the principal sum of a loan or deposit is called compounding. Compound interest is interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously-accumulated interest.
Looking at that definition, you may be confused, and trust me, you’re not the only one. Let’s look at a easy example:
Say you have $100, and your account earns 10% a year, or simply: $10.
Now after two years, in theory you will have now earned 20%, or simply: $20.
However, you earn interest on the $10 from the first year, and that goes into the second year, so at the end of Year 2, you actually have: $121.
I know what you’re thinking, big deal, I made a whopping $1 extra over two years, which when you compare the simple interest ($120) vs compound interest ($121), is basically nothing. Look back at what you started with though, $100. In the two years, you made an extra 1%. At $100, an extra one percent is only a dollar, but if you have $1m, that extra one percent is ten thousand dollars.
The point of this concept is no matter how much money you start out with, the more you save, the easier building wealth becomes. If you look at the stock market from 1950 to 2016, the average return is about 7% a year. This means for every $100 you invest, you can expect to get about $7 back annually. Some people decide to not invest, and leave their money in a bank account. The average savings account at banks pays about .01%, or roughly ten cents per hundred dollars. This means investing, on average, pays 70x MORE than keeping your money in a bank account.
Still not convinced? Let’s spice this up just a bit more. A lot of investments will pay what’s called a “dividend,” which is basically just a reward that is given to shareholders based on company performance. Most dividends are about 1-3% a year, and are paid monthly, quarterly, or annually. Add this return to your average 7% return, and you could be getting upwards of 10% return on average.
Why is all of this stuff important? Refer back to the beginning where we talked about buying a house, car, traveling, etc. If you have $1m in investments, and your getting a 7-10% return, you can expect to earn between $70-$100k a year, without lifting a finger. Now a million dollars is a lot of money, how could you ever expect to save that much?! You don’t have to, in fact, you don’t even need to save half of that. If you start saving now, and let compound interest do its magic, you’ll see $1m is more achievable than people realize. And if you have TIME, that number could become much bigger…
If you’d like to start investing, companies such as TD Ameritrade, JP Morgan, Vanguard, or Scottrade are great places to start!
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