Compound Interest: The Eighth Wonder of the World

“Compound Interest is the eighth wonder of the world.

He who understands it… earns it.

He who doesn’t… pays it.”

– Albert Einstein

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I’m sure you’ve heard the words “compound interest” at some point in your high school life. But, I bet you don’t quite understand what the power of compound interest really is…

The HSC standard math syllabus forces you to scratch the surface of compound interest through the financial math topics. You’ve probably heard your business teacher ramble on about it. I bet you’ve heard your grandparents mention it too (if you were actually listening).

But, do you actually know what it is?

If you haven’t learnt something new by the end of this post, I will personally shake your hand for being a badass human… Get reading!

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What is compound interest?

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You’re busy, I get that and I respect the hustle. So, I’m gonna keep this short and sweet!

Interest is the reward you get paid for loaning your money to a financial institution. It’s kind of like their payment to say thanks for letting us use your cash.

Compound interest is defined as:

Interest calculated on the initial principal, including any interest already earned and added to that principle.

Basically, it occurs when you earn interest on interest.

Be Careful: Compound interest can also work against you! This occurs when you borrow money from a bank. The bank charges interest as a fee for borrowing their money and if you don’t pay down the balance, the interest amount grows each year.

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An example of compound interest

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Let’s say you have $500 in a bank account that pays a 10% interest rate per annum (per year).

• After the first year, that account is now worth $550 (500 + (0.1 x 500) = 550)
• After the second year, that account is now worth $605 (550 + (0.1 x 550) = 605)
• After the third year, that account is now worth $665.50 (605 + (0.1 x 605) = 665.5)

As you can see, the interest rate never changed over these 3 years, but each year you earned more interest. So how does that work? Well, let’s take a look:

• In year 1, you earned 10% interest on the initial investment
  • 10% of $500 = $50
  • Total interest = $50
• In year 2, you earned 10% on the initial investment + 10% on year 1’s interest
  • 10% of $500 = $50
  • 10% of $50 = $5
  • Total interest = $55
• In year 3, you earned 10% on the initial investment + 10% on year 1’s interest + 10% on year 2’s interest
  • 10% of $500 = $50
  • 10% of $50 = $5
  • 10% of $55 = $5.50
  • Total interest = $60.50

I hope this made sense. Essentially, each year you’re earning interest on the initial investment along with everything it’s already earned.

This is why we call it compounding, because it increases each year.

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Because you’re reading this:

Check out Uncle Nathan’s Breakdown of what a Credit Score is and why you’ll never buy a house without it…

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How can compound interest make me rich?

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Let’s think about it:

If you invest a decent chunk of money into an asset that pays 10% interest each year, that 10% will start relatively small. But, before you know it, you’ll be earning 10% on the initial amount plus years worth of already earned interest!

Let’s take a look at a practical example where I’m depositing $1,000 every month into an account that also earns 10% each year, compounding monthly.

As you can see, my initial $10,000 earned very low amounts of interest in the first 10 years. But, after that, it skyrocketed!

Between year 1 and year 10, my $10,000 increased $130,000 (which is still heaps).

After that, between year 10 and year 20, it increased $600,000! And then between year 20 and year 25, it increased another $619,000 (in just half the time of the last period).

If this doesn’t show you the power of compound interest, I don’t know what will…

P.S. Try this calculator out for yourself! Available from the ASIC MoneySmart website.

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How can I start compounding my money?

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Now, I know 10% interest rates are extremely rare (unless you’re taking out a loan…). Currently, interest rates are at record lows in Australia, and the RBA has forecast this to remain the same for at least the next 12-18 months.

So, here’s what I do to hit as close to that 10% as possible each year:

• First, I save $1,000 each month in a high-interest savings account
• Then, I take that $1k and invest it into a moderate growth, high dividend stock (usually a REIT)
• From there, I enrol in the REITs DRP (Dividend Reinvestment Plan) so the dividends (interest) are reinvested automatically for me each quarter

This allows me to hit around 8% each year (compounded quarterly), plus any capital gains on top of that (this occurs when the stock price increases).

I plan on leaving this strategy to do its thing for the next 25 years. Throughout which, I’ll be increasing my earning capacity to start the same strategy with other stocks.

To learn how I invest and how to get started, have a read of Uncle Nathan’s Ultimate Guide to Investing for Beginners.

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Final Word

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Anddddd that’s all there is to it!

A simple concept with a complex application. Understanding compound interest is the easy part, apply it to your finances is what’s harder.

If you can use the power of compounding combined with these three things, I can promise you’ll be wealthier than you ever imagined:

• The Big Secret to Being Rich in 2021
• How to Avoid the 10 Money Mistakes Every 20-Year-Old Makes
• Why Your Hosue isn’t Actually an Asset

Enjoy your new wisdom! If you found this valuable, share it around your circle and spread the love, or just comment down below to help a brother out…

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Until next week,

Uncle N.

The information on this page is for informational and educational purposes ONLY. It does not take into account your personal financial needs, objectives or situation. For specific financial advice, speak to a registered financial advisor.