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How Money Works Educator - Dan Blanchard

Dan Blanchard

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Compound Interest: Math Or Magic?

Compound Interest: Math Or Magic?

October 21, 2020

Compound Interest: Math Or Magic?

If you don’t think there’s anything awe-inspiring about compound interest—think again.

Albert Einstein asserted that it’s mankind’s greatest invention. He deemed it “the eighth wonder of the world”.(1) That’s the same guy who came up with the theory of relativity! On the other hand, Thomas Aquinas, the influential medieval philosopher and theologian, thought charging interest was unnatural and unjust.(2) How could a coin grow more coins without dark magic at play? That’s not how money works, right?

If you’re still scratching your head wondering why they had such strong reactions, let’s break down how compound interest works and see what the hype is really about!

What is compound interest?
Merriam-Webster defines compound interest as “interest earned on principal plus interest that was earned earlier.” Let’s clarify that definition.

Let’s say you put $10,000 into a bank account that pays 5% interest annually. After 1 year, the bank will pay you $500 for letting them hold your money. The next year they’ll pay you 5% of $10,500, which comes out to $525. You now have $11,025. This will keep repeating until you withdraw your money.

In the short term, that doesn’t seem like such a big deal. Having an extra $1,000 is nice, but that won’t get your family to Disney World and back. However, over time those little gains start to accelerate. After 10 years you would have $16,289. Another 10 years would bring the total to $26,533 (more than double what you started with). After 50 years your $10,000 would have grown into $114,674. That’s over 10x as much as you started with! And that’s with no effort on your part. Your money is growing more money!

Things to consider
A few things to keep in mind when working with compound interest. Your interest rate is a key driver on how quickly your money will grow when it’s compounding. Swap out the 5% interest rate for 1% and you’ll only wind up with $16,446… after 50 years. But crank the rate up to 10% and your 50 year total is $1,173,909!

Monthly contributions also make a big splash on your compound interest outcome. Just contributing $100 a month to your initial $10,000 dollars with a 5% interest rate more than triples your total to $365,892!

So… is it magic?
Those calculations may seem like sorcery. But you don’t need a book of magic spells to leverage compound interest and put your money to work. It just comes down to simple math that we’ve known about for centuries.(3) The key to growing your money is to think of it like a seed rather than something you exchange for a good or service. Make plans to meet with a licensed financial professional to discuss how the power of compound interest can help lay the groundwork for your savings strategy.

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