Compound Interest, Part 1: A Powerful Phenomenon

Compound Interest, Part 1: A Powerful Phenomenon

The Northern Lights, illustrating the phenomenon that is the power of compound interest.
Another phenomenon – Aurora Borealis, also known as The Northern Lights.
YUCH Northern Lights” by NPS / S. Tevebaugh, Public Domain license

You may view the concept of compound interest as simply a boring financial term that you (fortunately) only have to deal with a few times in your life, such as while applying for a credit card or slogging through mortgage origination paperwork.

But if you’re reading this article, it’s probably safe to assume that you’re interested in either ending the stranglehold your finances have you in, increasing your bottom line, or becoming independent of a paycheck. Maybe even all three.

If that’s the case, we need to revisit this concept of compound interest. It is one of the most powerful forces in the universe, and it has the potential to change your life.

Today’s post constitutes the first installment of a 5-part series detailing the massive impact compound interest can have to both speed and sabotage your journey to financial freedom.

The Life-Altering Potential Of Compound Interest

A mere knowledge of the might of compound interest can forever change the way you think about money. By so doing, it becomes the key which can open the door to your financial freedom, transforming dreams into reality and changing your life in the process.

There is no more powerful or important personal finance concept. As you will see from the upcoming articles in this series, harnessing its phenomenal power has the ability to better your bottom line by hundreds of thousands of dollars.

This can be the difference between living paycheck to paycheck and being able to give generously to friends, family, and charity. Between not having to choose between a second income and a family. Between retiring in your 30’s or 40’s and slaving away until you’re 70.

My goals for this series on compound interest are to inspire you with its potential, warn you of its dangers, and equip you with the information needed to employ it in support of achieving financial freedom and pursuing your dreams.

A Powerful Phenomenon

Phenomenon (fi·nom·uh·non), noun:

  1. Any extremely unusual or extraordinary thing or occurrence;
  2. An unusual, significant, or unaccountable fact or occurrence; a marvel;
  3. A fact or event considered very unusual, curious, or astonishing by those who witness it;
  4. A fact, occurrence, or circumstance observed or observable.

Those who observe the power of compound interest are often left marveling in astonishment, a not-unusual reaction after witnessing other phenomena such as the Northern Lights.

Compound interest is such a powerful mathematical phenomenon that Einstein himself is said to have referred to it as “The 8th Wonder of the World”.

Some other quotes regarding compound interest which are frequently attributed to Einstein:

“Man’s greatest invention.”

“He who understands it, earns it… he who doesn’t, pays it.”

“The greatest mathematical discovery of all time.”

How about the take of the 3rd-richest man in America?

“My wealth has come from a combination of living in America, good genes, and compound interest.” – Warren Buffett

That’s high praise, from some of the world’s best and brightest. So what exactly IS compound interest that it inspired these individuals to speak of it in this way? Let’s take a look.

A Basic Interest Calculation

First, let’s review the basic concept of interest, using a nice round $100 balance in a savings account with a 1% interest rate compounding once per year.

Basic math tells us that 1% of $100 (.01 x 100) = $1.00.

Our $100 savings account balance will therefore generate $1 in interest income every year. After ten years, it will have generated a total of $10 in interest; after 50 years, a total of $50 in interest. No mystery here, right?

A Compound Interest Example

Wrong – there’s one small detail we’ve overlooked, and it makes a world of difference.

The above calculations assumed that every year we had only the original $100 balance in our savings account. After the first year, this would only be true if we annually withdrew the $1 generated in interest.

Assuming we had not, our balance after year one would be $101. This means the interest generated at the conclusion of year two would be on not just our original balance, but on the original $100 balance PLUS the $1 in interest earned the year before.

Compound interest derives its name (and incredible power) from the fact that it is interest earned on previously accumulated interest – in other words, interest payments which continually grow over time.

Our interest earned at the end of year two is therefore 1% of $101 (.01 x 101) = $1.01. A penny more than the $1.00 we earned the year before.

How can a simple penny change your life, much less qualify as a wonder of the world? You can find the answer to that question in the ensuing articles within this series.

Up Next – Compound Interest, Part 2: Your Rocket To Riches

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