Compound Interest Will Either Build or Destroy Your Wealth

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So many financial articles that you can find will hail the benefits of compound interest. But compound interest can work against you just as much as it can work for you. 

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” ~ Albert Einstein

You want to understand it and be the one earning it, not paying it.

Basics of Compound Interest

The basic math behind compound interest is that it is interest calculated on top of interest.  So an example would be if you had invested $10,000 that was earning 10% interest compounded annually, then after year 1, you would have $11,000.  Which is comprised of your original $10,000 investment plus $1,000 interest earned.  At the end of year 2, you would have $12,100, which is comprised of the $11,000 that you had at the end of year 1, plus $1,100 in interest.  Wait, how did we get $1,100 in interest the second year versus the $1,000 in year 1?  That right there is the benefit of compound interest, you’ve just earned interest on top of interest.  The additional $100 in interest in year 2 is the 10% interest earned on the $1,000 in interest earned in year 1.  Plus you also make the $1,000 in interest on your original investment in year two as well, which is how you receive $1,100 in year two versus the $1,000 in year 1.

Compound Interest to Explode Your Wealth

Now as noted in Albert Einstein’s quote above, you want to be the one earning it, not paying it.

Given the example investment above, you can see the small benefit in year 2 when you are starting to earn interest on interest (compound interest).  But when you let this balance grow over a more extended term, you start seeing tremendous results.  Over 20 years compounded annually, your original $10,000 investment would be worth $67,275, and in year 20 you would have earned $6,116 in interest.  Now the benefits of compound interest are really starting to shine.

The examples made above also shows you the benefits of starting to invest and save as early as possible in your life and career.  The longer time horizon you give your money to grow and earn compound interest the more significant the benefits that you’ll see.  When done right, your wealth will explode in value and set you up to live a much more prosperous life.

Compound Interest That Will Destroy Your Financial Success

Now as noted in Albert Einstein’s quote above, you want to be the one earning it, not paying it.  What do I mean by this?  Compound interest can work against you just as quickly as it can work for you.  An example of it working against you is if you carry a credit card balance and don’t pay off the balance in full each month.  For those that are carrying a credit card balance (assuming you don’t have a 0% interest deal) when your credit card issuer charges interest, they charge it on your full balance.  So if you haven’t paid your balance in full and get charged interest on it and then don’t pay the balance in full again the next month, they are charging you new interest on top of the interest that they charged you the prior month.

This is compound interest working against you.  And it will work just as hard against you as it works when it is working for you when you are earning it.  This is another reason why it is imperative that you don’t carry a balance on your credit card.

Compound interest working against you is one of the reasons why I encourage you to focus on eliminating debt before you work on building wealth.  If you don’t eliminate debt, compound interest will work against you and destroy your chances at financial success.  What do you need to do today to make sure that compound interest doesn’t destroy your financial success, but instead sets you up to reap the benefits and start building wealth?

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GP

Hi, I'm GP. A personal finance expert with a mission to help Entirely Money readers break free of money worries. Combining a finance-focused education background (B.S. in Finance and MBA with Finance focus) with over 15 years of personal and corporate finance experience to help you achieve your financial best life!

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