July 31, 2016

The Magic Of Compound Interest – Grow Your Savings!

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.

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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.

Compound interest can be calculated using the following formula:

FV = PV (1 + i)^N

FV = Future Value (the amount you will have in the future)
PV = Present Value (the amount you have today)
i = Interest (your rate of return or interest rate earned)
N = Number of Years (the length of time you invest)

Who Wants to Be a Millionaire?

As a fun way to learn about compound interest, let's examine a few different ways to become a millionaire. First we'll look at a couple of investors and how they have chosen to accumulate $1 million.

1. Jack saves $25,000 per year for 40 years.
2. Jeff starts with $1 and doubles his money each year for 20 years.

While most would love to be able to save $25,000 every year like Jack, this is too difficult for most of us. If we earn an average of $50,000 per year, we would have to save 50% of our salary!

In the second example, Jeff uses compound interest, invests only $1, and earns 100% on his money for 20 consecutive years. The magic of compound interest has made it easy for Jeff to earn his $1 million and to do it in only half the time as Jack. However, Jeff's example is also a little unrealistic since very few investments can earn 100% in any given year, much less for 20 consecutive years.

TIP: A simple way to know the time it takes for money to double is to use the rule of 72. For example, if you wanted to know how many years it would take for an investment earning 12% to double, simply divide 72 by 12, and the answer would be approximately six years. The reverse is also true. If you wanted to know what interest rate you would have to earn to double your money in five years, then divide 72 by five, and the answer is about 15%.

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