August 6, 2009
Albert Einstein called compound interest “the greatest mathematical discovery of all time”. We think this is true partly because, unlike the trigonometry or calculus you studied back in high school, compounding can be applied to everyday life.
The wonder of compounding transforms your working money into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on an assets re invested earnings. To work, it requires two things: the re-investment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.
To demonstrate, let’s look at an example: If you invest 10,000 today at 6%, you will have 10,600 in one year (10,000 x 1.06). Now let’s say that rather than withdraw the 600 gained from interest, you keep it in there for another year. If you continue to earn the yearly rate of 6%, your investment will grow to 11,236.00 by the end of the second year.
Consider two individuals, we’ll name them X and Y. Both X and Y is the same age. When X was 25 she invested 15,000 at an interest rate of 5.5%. For simplicity, let’s assume the interest rate was compounded annually. By the time X reaches 50, she will have 57,200.89 in her bank account.
X’s friend, Y, did not start investing until he reached age 35. At that time, he invested 15,000 at the Ye interest rate of 5.5% compounded annually. By the time Y reaches age 50, he will have in his bank account.
What happened? Both X and Y is 50 years old, but X has 23,713.74 more in her savings account than Y, even though he invested the yearly amount of money! By giving her investment more time to grow, X earned a total of 42,200.89 in interest and Y earned only 18,487.15.
Both X and Y earnings rates are demonstrated in the following chart.