Updated: Feb 5, 2019
Compound interest. I think I've heard of it. Somewhere in the obscure, darker recesses of my brain I have a faint memory of a teacher talking about it. Maybe in an Econ class? Or an accounting class, maybe? Or a banking class? Or maybe it was my dad trying to explain it to me,I don't know. I was probably uninterested to learn about it back then, before I cared about my financial future, but now I've learned that it's one of the most important tools in my arsenal for successful long-term investing.
What is compound interest? How does it work? And how can I utilize it for my portfolio to help me create passive income for the future? To put it simply (and technically),Compound interest is the interest an investor earns on his or her original investment plus all the interest earned on the interest that has accumulated overtime (Phew! That's a mouthful). Or in other words Compound Interest is earning Interest on interest (Don't think I've ever written the word interest so many times in one sentence)
Don't worry if you're still confused. An example always helps:
Jim puts his money into a savings account (because he's a financially responsible young man) that earns him, let's say 10% annually (savings accounts these days give you much less than that. Maybe 1-2% if you're lucky, but for the sake of the example we'll use 10%. Work with me here). He decides to put in $1000. At the end of one year, earning 10% interest, he makes
an additional $100 bringing his total to $1100.
Now the second year he earns another 10%, but instead of earning it off of the original amount or principle ($1000) he now earns it off the $1100 that's currently in his savings account. So, at the end of Year 2 he earns $110 (.10 X 1100) bringing his total to $1210. And like this, Jim continues to earn money as the years go by.
As you may have already guessed, the longer Jim keeps his money in his savings account and doesn't touch it, the more money he'll make in compound interest. You can see how much money Jim will earn in compound interest over a 10 year span:
In ten years time he'll have earned about $1300 dollars in interest ($2357.95-$1000=$1357.95). Now, this may not seem like a whole lot of money in 10 years time (cause its not), but remember Compound Interest is only one component of our methodology for investing our money. We also have to talk about Dollar-Cost-Averaging, which I will explain in the next blog post. Combining Dollar-Cost-Averaging and Compound Interest is when things get really exciting and you can make some serious money for your nest egg.
Feel free to check out this 2 min video from Investopedia explaining Compound Interest if you're still confused or just need more visual aids: