Einstein calls it the 8th wonder of the world, it is the thing that makes people wealthy and brings people to bankruptcy. Yes, today we are going to talk about compound interest.
What is Compound Interest?
Compound interest is when you get paid interest on top of your principal, and the interest. For example let’s say you have £100 invested and get a 10% compound return. That means on the first year you will get £110, but the next year your are going to get 10% of £110 instead of £100, or £121. The year after you are going to get 10% of £121 and so on.
Yes at first the difference does not sound like a lot, but bear with me. The trick with this one is that it shows it’s magic over time. In the first 2-3-5, even 10 years it might not seem that much, but if you give it time it is going to make you rich. In this article we will go through scenarios and examples of how that happens.
Simple vs Compound Interest
As you might know there are two types of interest – simple and compound. You now know how is compound interest calculated, but now let’s check out the simple interest.
Simple interest is when you get interest only on your principal. Let’s get back to the example from the top. You have £100, but this time you get 10% of simple interest.
That means that you are going to get 10% of £100 every year. For example in your first year you are going to get £110, but in the second year you are getting 10% of the initial £100. That means the second year you will have £120, £130 in the third and so on.
This works great when you have to pay off debt or any sort of loan. But it is not great when you want to get returns on your investments.
Why is Compound Interest so Powerful?
Honestly it is hard for people to understand how compounding your money over time might actually do wonders. This is mostly because it is hard for people to think long-term. It is also hard for people to stay away from short-term temptations.
After all if you have a £1000 and you get 10% return anually that means in a year you will have 100 quid on top. It sounds decent, but it is not something that will change your life.
After all you can buy some fancy clothes with the money and continue living your life right? Yes, of course you can, but you can also make some calculations and see what I mean.
Examples
Example A is Danny, while example B is Johny. Both of them receive £10,000 as an annual bonus from their company every year. That is great for them, now let’s check out what they are planning to do with their money.
Danny decides to save the money, learn a little about Investing and try to work out a better future for herself. She makes a little research and decides to invest the money in Stocks. She builds a simple Portfolio of ETFs and is able to generate 10% with dividends reinvested.
She sees the effects of that and starts investing the annual bonus every year.
On the other hand Johny prefers to spend the money on a new car, fancy clothes, fancier place to live etc. He doesn’t think about the future and prefers to spend his money on different things that make him feel better about himself.
The difference is that Danny is thinking in the long-term while Johnny is thinking in the short-term. Now let’s check out what happens :
Fast forward 10 years and Danny now have a portfolio of over £200,000. On the other hand Johny have long forgotten about all the things that he has bought over those years.
The interesting part is that he gets interested on Danny’s strategy after he sees the results. Now he wants to learn more about investing. He decides to try and use the money to build a portfolio himself. With a little education he manages to also achieve 10% return with dividend reinvesting.
Inspired by Danny and seeing the results himself he decides to keep deploying his annual bonus in his portfolio.
Examples 15 Years Later
With the power of compounding Danny is now the owner of a portfolio worth £1,2mln. Johny’s portfolio is worth £390,000.
As you can see they are both doing well, but Danny now have almost a milion more than Johny because she started 10 years earlier. They are both investing the same money with the same returns, but the difference is that Danny had 10 years of compounding on her side.
An interesting fact is that Danny now needs only 5 years more and her portfolio is going to be worth £2mln.
Hope you understand the amount of money you can make just from investing your annual bonus/ tax return/ side income every year.
To be honest with you not everyone understands the power of compounding, because people in general think in the short-term. There is a great quote from Einstein on this matter.
”Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein
This quote brings me to the next part.
How to Use Compound Interest
Now you have figured out that compound interest is a great thing. Let’s check out the possible ways to use it.
Stock Market
The first and most obvious way to use compounding is by investing in stocks. Here you have a couple of different ways you can compound your returns.
You get capital appreciation and you get dividends on top of that. Then your dividends are growing consistently giving you another stream of compounding. By reinvesting those dividends you get an even extra boost to get the snowball rolling.
Real Estate
This is another way to get the compounding on your side – by having rental properties. The mechanics are very similar to the ones in the stock market. You get a couple of rental properties and instead of dividends you get rent every month, which is also growing annually.
Again you get 3 different streams of compounding – capital appreciation, rent income and also rent increases.
Own Business
There are a lot of different way you can build a business that enjoys the power of compounding, in fact most businesses do.
You can achieve that simply by scaling your business and reinvest the profits back to it in order to make even more profits.
For example if you have a shop you can reinvest the profits and open another shop. Then you can open another one and another one and so on. The principle is again very similar to rental properties or stocks, but instead of buying more stocks or units you are expanding your business.
How Not to Use Compound Interest
So far we have learned that compound interest can be a wonderful thing, but it can also be a horrible one. That happens when you let it work against you.
The easiest way for that to happen is if you start stacking on credit card debt. The interest there in most cases is compound, which means that you are paying not only interest, but interest on top of it.
In most cases the credit card rates are pretty high, usually starting at at least 10%. For example the rate on my credit card is a hefty 35%.
Yes, when your balance is not very big it might not seem like a lot, but if you let the situation get out of control you can get in big trouble.
For example let’s say that you have a credit card balance of £2,000 on 35%. If you stop paying it in 5 years that balance would now be £11,000. For 10 years it will be an astonishing £63,000 and that is not counting any fees.
This is why you should pay off your credit card in full every month. If you leave it just for a couple of months you can get the snowball rolling and soon you can be hit by an avalanche of compounding.
This is why you should be smart and get the power of compounding on your side. It is not a wise decision to have it playing against you.
Examples
All of this talk about compounding is great and all, but you are probably interested to know some real-life examples who benefitted from it.
A bit furter up I gave you the most common ways to generate wealth from compounding. Now let’s check out one example from every group.
Warren Buffett
Here of course we are going to check out Warren Buffett. For those of you that are not familiar he is the 3rd richest man in the world with net worth of over $80bln.
The interesting part is that he started with nothing and used the power of compounding to gain that incredible wealth. He managed to do that by investing in the stock market since he was 14 years old.
His massive 20% annual returns have been of huge help for him and the main driver of his wealth. Here is a graph of his net worth over time.
As you can see he started with only $5,000, which he has accumulated doing different jobs. Then he had his plan and invested everything into the stock market and you can see the results.
”My wealth has come from a combination of living in America, some lucky genes, and compound interest.” – Warren Buffett
Donald Bren
A good example of successful use of compounding in the real estate is Donald Bren. He is the founder of the Bren Company, a home-building company. He has used the money generated from it to later on purchase a big stake in Irvine Company. He has started his investment portfolio with a $10,000 loan to build his first house.
Fast forward to today Irvine Company is one of the largest real-estate developers in the world, operating a huge number of properties in land in the USA. That made Donald Bren one of the wealthiest people in the world with a net worth of over $15bln.
Jeff Bezos
The best and most recent example of massive success in the business world is Jeff Bezos. He is the CEO of Amazon, a company which he founded 24 years ago.
He used the power of compounding by constantly reinvesting all the income back in the business. As a result it is now one of the biggest companies in the world and Bezos is the richest person in the world as of today.
Just to give you a little bit of perspective what that constant reinvestment has achieved for the company. Since it went public in 1997 the share price of Amazon has increased more than 1200 times!
For example if you have invested just $100 in the company back then you would now have around $120,000 (The value is as of April 2019). Crazy, right?
Conclusion
Now you understand why is compound interest considered the 8th wonder of the world by Albert Einstein.
There are two options ahead of you – you either start using it working for you or against you.
I hope that if you are reading this you can see the power of compounding and you will bring it in your team moving forward.
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