The Eighth Wonder of the World
The seven natural wonders of the world are the Aurora Borealis (Northern Lights), the Grand Canyon, the Great Barrier Reef, Mount Everest, Victoria Falls, Parícutin and the Harbor of Rio de Janeiro. Albert Einstein, in all of his genius glory identified an eighth natural wonder known as compound interest.
"Compound interest is the eight natural wonder of the world and the most powerful thing I have ever encountered. He who understands it, earns it... he who doesn't... pays it."
Albert Einstein
What is this eighth natural wonder exactly? How does it work? And why should you and I have any interest in it?
What is compound interest?
Compound interest is the addition or reinvestment of interest into the capital sum of a loan or deposit. Make sense? Good, lets go. Actually, not so fast because even just writing that had me a bit confused. There has got to be a better way of explaining it. Think of compound interest this way: Imagine pushing a small snowball down a hill. As it rolls, it continuously picks up more snow and eventually becomes a gigantic snowball by the time it reaches the bottom of the hill.
The snowball compounds as it rolls down the hill. Compound interest works the same way. The best explanation of compound interest comes from none other than the man whose face is on the $100 dollar bill. Benjamin Franklin explained compound interest this way:
Money makes money. And the money that money makes, makes money
How does it work?
The beauty of compound interest is that it requires little action or effort on our part. In fact, the case can be made that the less we do, the better. As described above, compound interest is simply your money earning money and then earning money in addition to the money it previously earned. Here is that same concept illustrated visually:
Here is how this works:
Suppose on January 1, you have $1,000 in a savings account and over the next 12 months, that principal sum will earn 5%. At the end of year one on December 31, your initial balance of $1,000 will have accumulated interest totaling 5% or $50 for a total principal sum of $1,050.
You immediately decide to reinvest the entire balance for a second year. On January 1 of this second year, your beginning balance of $1,050 will continue to earn 5%. On December 31 of year two two your beginning balance of $1,050 will have accumulated interest totaling 5% or an additional $52.50 for a total principal sum of $1,102.50.
The process simply repeats as illustrated above in years three through six. Not only does the velocity of your interest increase but so too does the growth of your principal. This is compound interest at work.
Why should you care about this?
There are two ways to answer this question. The simple answer is that by taking advantage of the forces of compound interest, you and I ultimately have to do less work to accumulate more wealth. When I say less work, I mean we have to save less. There are three inputs to growing wealth: The money we save, our average rate of return and the time we have to grow our money. With enough time and a market average rate of return, less savings is required to reach our goal. This is why it is important to begin saving early and often. However, even if you began saving later in life, compound interest will still serve you well - you just have to give it more time to work and it may require more aggressive savings on your part in order for you to reach your goal.
There is another reason you should care about compound interest. Recall the latter part of the quote attributed to Albert Einstein in the beginning of this article: "...he who understands it, earns it. He who doesn't... pays it." Just as compound interest is effective in helping you to grow your assets, it has an inversely negative effect on your liabilities. In other words if you hold debt that accrues interest and you're not able to pay off the principal balance of the debt, you will suffer from the effects of compound interest.
So, whether you're a investor or a deficit spender, compound interest touches your life. If you owe debt, be aware of how this force works against your interest and make every effort to eliminate the principal balance you owe. For the rest, take advantage of the time you have to leverage this powerful force for your benefit, to help you accumulate and sustain your personal wealth for years to come.