Calculating Compound Interest Basics
Compound interest is, “interest which is calculated not only on the initial principal but also the accumulated interest of prior periods.” Albert Einstein referred to compound interest as the “8th wonder of the world.” It’s the same powerful concept that keeps millions of people in debt to their creditors, yet also produces millions of dollars when practiced over a long period of time.
The biggest misconception about money is that people believe $25 spent today is worth $25. This is not true! You are forgoing opportunity cost as well, which is the decision to go in one direction or the other. While some may spend that $1 today, you may choose to save and invest the money instead.
You can calculate compound interest using a formula to determine the future value of $25 saved today:
Compound Interest Formula
FV = PV (1+i)^n
FV= future value
PV= present value
i= interest rate
n= # of years
For this example, we’ll assume that $25 earned a 9% annual return (the average between historical small cap stock returns and long term bond yields) over the course of 25 years. Now, we plug and chug the numbers into the compound interest equation:
FV = $25 (1.09)^25
The result of future value is $215. $25 grows to nearly 9x its value as an investment, rather than an expense. If you account for inflation, then the return is reduced to $107, over 4x as much as you started with.
Start Investing Early and Compound Interest Will Work Hard for You
Start investing early and often. Time is a dimension that we have zero control over. You can start off by investing $20 a month when you’re 20, and will end up with more money than someone who started investing $100 a month when they’re 30. Money can be replicated, but time is irreplaceable.
Small amounts count. When I learned this equation in school, I believed the magic of compound interest only applied to large sums of money. I was wrong. $1 will compound as much as $100, provided that annual returns are equivalent. If you have $20 left over from your monthly budget, then re-invest the money so you can earn more money later. Don’t view it as frugal; view it as a smart investment.