The Magic of Compound Interest

When you were a kid, perhaps one of your friends asked you the following trick question: "Would you rather have $10,000 per day for 30 days or a penny that doubled in value every day for 30 days?" Today, we know to choose the doubling penny, because at the end of 30 days, we'd have about $5 million versus the $300,000 we'd have if we chose $10,000 per day.

Compound interest is often called the eighth wonder of the world, because it seems to possess magical powers, like turning a penny into $5 million. The great part about compound interest is that it applies to money, and it helps us to achieve our financial goals, such as becoming a millionaire, retiring comfortably, or being financially independent.

Albert Einstein once noted that the most powerful force in the universe was the principle of compounding. In investing, this manifests itself through something called compound interest.

Compound interest is what happens when interest has the chance to build on itself over time. Compound interest is accrued interest that is added to the underlying assets, or principal. Over a long enough time period, that interest builds up higher and higher…until you’re looking at either a very cushy nest-egg.

A dollar invested at a 10% return will be worth $1.10 in a year. Invest that $1.10 and get 10% again, and you'll end up with $1.21 two years from your original investment. The first year earned you only $0.10, but the second generated $0.11. This is compounding at its most basic level: gains begetting more gains. Increase the amounts and the time involved, and the benefits of compounding become much more pronounced.

It is the reason for the success of every person on the Forbes 400 list, and anyone can take advantage of the benefits through a disciplined investing program. Benjamin Franklin was famous explaining to people that it was the best way he knew how to get rich.

Three things will influence the rate at which your money compounds. These are:

1. The interest rate you earn on your investment, or the profit you earn. If you are investing in stocks, this would be your total profit from capital gains and dividends. Consistently higher returns significantly increase the effects of compounding over time.

2. Time. The longer your money can remain uninterrupted, the bigger your fortune can grow. It's no different than planting a tree. Naturally, the tree is going to be larger when it is 50 years old than it was when it was 20 years old.

3. The tax rate, and the timing of the tax, you have to pay to the government. You will end up with far more money if you don’t have to pay taxes at all, or until the end of the compounding period rather than at the end of each year. Any rate lowering effects add tremendous value to increasing your overall returns.

That’s why maximizing each of these three elements is crucial to your long-term investing success!

Compound interest can help you attain your goals in life. In order to use it most effectively, you should start investing early, invest as much as possible, and attempt to earn the best possible rate of return. Real wealth is really attainable when using solid investment principals and sticking with a plan!