Have you ever spent your money on something that you thought that you absolutely had to have only to regret making the purchase one second after you leave the store? You are not alone. This is a normal feeling. Especially amongst people who know about compound interest.
Compound interest is when your money makes you money. It is when your money just keeps building on top of itself without any extra input from you. In infomercial terms you would just "set it and forget it". An example of compound interest would be if you were to put $1,000 in an account that earns you 5% interest annually. That means that after one year your $1,000 dollars would now be $1,050. Your money would have made you $50. The five percent interest would get added onto your $1,000 principle. This is where the compounding interest would come into play.
If you were to leave your money in that account you would enjoy a second year of earning a 5% interest on your money. The difference between year one and year two is that in year one you earned 5% on the $1000 dollars that you invested in the first place while in year two you earn 5% on $1050 which is the initial principle plus the interest that you earned from year one. So after year two you would now have $1102.50 in your account. That is the sum of your initial principle plus your interest from year one plus your interest from year two. The key thing to note is that in year one your money only made you $50 dollars while in year two your money made you $52.50. That is compound interest.
If you are thinking that this is not a big deal because in the example you only made an extra $2.50 from the compounding interest then you are crazy. Stop thinking small. In the investment world $1,000 dollars is an extremely minor investment. It is a place to start not a sum that you just invest and never put anything in. The compounding interest in the example using only $1,000 is nothing. If your investment was $10,000 you would have made and extra $25 in year two. If your investment was 100,000 you would have made an extra $250 in year two. If your investment was $1,000,000 you would have made an extra $2,500.
Keep in mind that the numbers that I gave you in the previous paragraph is not the total amount of interest that you would have earned on your money in year two. It is only the extra amount that you would have made through the power of compounding interest. For instance, if your investment was one million then at the end of year one you would have made $50,000 from the five percent interest rate giving you a total of $1,050,000. If you were to take that $50,000 interest that you earned out of the account and chose to only earn the 5% interest rate on your principle then you earn $50,000 again. However, if you were to leave the $50,000 in the account thereby allowing your interest to earn interest right along with your principle then you would earn $52,500 on your investment. If you were keep doing this for 30 years the difference would be enormous. If you were to take the interest out every year over a thirty year period then your investment would have earned you 1.5 million and you would still have the 1 million in the bank for a total of 2.5 million. If you would have allowed your interest to compound you would have $4,321,943. That is about an extra two million dollars you would have made by letting your interest compound. I do not think I need to say anything else about that.
NaQuan L. Gray is a finance major at the Pennsylvania University School of Business. His goal is to educate people on money management and to show people how financial literacy can improve the quality of their lives. To read more articles from this author visit his website at http://www.astonagendas.com.
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