George Lucas continues to mislead millions of people into believing that the most powerful force in the universe is, well … the Force. But every successful household CEO knows for a fact that Lucas is dead wrong. That is not surprising at all given that Lucas is a filmmaker and not an astrophysicist. After all, legend has it that Albert Einstein — the true authority on this topic — said, “there is no greater power in the universe than the power of compound interest.” And has there ever been a greater authority on the universe than Mr. Einstein?
Honestly, who could argue with old Al on this? Yes, he’s dead, but let’s not quibble over technicalities.
Here’s a simple example: If you start with just a single penny and double it every day, how long will it take you to reach one million dollars? One year? Six months? Believe it or not, it would only take 28 days. To be specific, at the end of 28 days you end up with … $1,342,177.20!
Score one for Einstein!
The original penny turned into two, but then those two turned into four, and those four turned into eight, and so on. If you still don’t believe it, take a calculator and enter 0.01. Then multiply that number by two. Keep multiplying your new number by 2 and count how many times it takes to get to one million.
In a nutshell, the growth of your money sped up because not only was your original penny collecting interest — but all of the pennies you received as interest also began to earn interest. This growth upon growth is known as “compounding,” and that’s where the term “compound interest” comes from.
If you’re not so keen on manually computing for compound interest, you can always use a daily compounding calculator for the next 28 days or however longer you choose if you’re computing for a long-term investment.
Interestingly, compound interest isn’t just applicable to one type of investment. Here are some other examples in which compound interest applies:
- Certificate Of Deposit (CD): In a CD, the money is tied up until the account reaches maturity. This investment is safe and issued by banks that offer higher interest rates than regular savings. A certificate of deposit pays interest rates at regular intervals, and you get the interest and principal as they mature.
- High-Interest Saving Accounts: This investment can cost a bit more than other investments. But they have a higher interest rate worth the extra money. While there’s inflation, these investments are low risk.
- Bonds: They make a great compound interest investment, wherein government bonds have the lowest risk, backed by the government. While bonds are subject to economic fluctuations, they have liquidity and are highly beneficial. Short-term corporate bonds are backed up by corporations with the highest risk but yield the greatest reward.
- Stocks: You can get more of the stock market through dividend-paying stocks with an additional payout. Choose your stocks wisely to get that dividend-boost you desire.
- Treasury Securities: You can participate in government projects by purchasing treasury bills that the government uses to invest in projects and pay debts.
- REITs: Real estate investment trusts allow you to earn money by dealing with a company that operates and owns real estate. You can own real estate or take part in rental properties without managing it. Choose publicly traded companies to benefit from REITs long-term.
Beware the Dark Side, Luke
Although the millionaire-in-28-days example is good for illustrative purposes, I’m now going to use a handy compound interest calculator to give a more common example of compound interest that occurs every day all across the world:
If you invest $100 at 6% interest at the end of one year you’ll end up with $106. And at the end of two years, the uninitiated might expect you to have $112. But in fact, thanks to the power of compound interest, you would actually have a total of $112.36. That’s because you not only received interest on your original principal of $100, but also on the interest you gained from year one (the additional $6.00). Compounding in action!
True, the $0.36 of extra interest doesn’t seem like a lot to get excited about. After all, the effects are hardly noticeable at first. But over time, compound growth becomes a, well … force of monumental proportions.
Like the mighty oak that starts out life as a lowly acorn, compound growth is something that must be nurtured over time — and the younger you are, the more opportunity you have to take advantage of the most powerful force in the universe when you’re saving and investing. Yes, patience you must have, young padawan.
Of course, you also have to avoid debt whenever possible because the Dark Side of compounding interest can also create financial holes that could overwhelm a Jedi Knight.
Successful household CEOs — including the millionaire next door — understand the power of compounding interest can be used for good and evil. And they use that knowledge as an incentive for saving, investing, and minimizing debt.
That’s right; just like the Force, the power of compound interest is truly a double-edged lightsaber that cuts both ways.
Photo Credits: (top) yapsnaps; pasukaru76
Definitely not your typical article on compound interest. Good job! Also, I like the layout of your blog. Old school for sure!
I agree, i like the layout. I also have to agree that I love the force of compound interest. One of my favorite topics!
Have you ever tried to find a savings account with compounding interest?
Where?????
As long as you leave the interest you earn in your savings account, your earnings compound over time.
I’ve had a trust fund growing in my name for about 20 years now, quietly growing, only being built up with compound interest and very conservative investment.
It’s been enough to support and pay for my schooling at a private university.
My parents were afraid that it was only going to barely hobble into the second or third year; instead I’m in year four, and will come out the other side with more than I started with.
So I, even at the financially young age of 21, am VERY much a believer in the time-proven power of that one little phrase.
People around me are worrying about the $100000+ in debt they’ll have to face in a few years; My wife and I are talking about our first house and retirement plans.
I can’t scream it enough: THIS. WORKS.
28 days to get $1,342,177.20??
Where do I sign?
Right now, inflation is high and returns on savings accounts are low. You’re lucky if you earn more than 1%. Maybe the older generation could save and expect it to grow but these days no savings or investment account even comes close to offering returns that account for inflation and rising prices in nearly everything.
I understand the power of compounding interest, and I’m in love with the idea. What no financial blog seems to address is there is no possible way to guarantee 6% or even 4% return. Most savings accounts these days don’t generate even half a percent, and the best are only around 1-2%.
We’re getting 2.65% on a…..(get this)….6 YEAR…..CD at local credit union. But by the time you factor in taxes and inflation, the real rate of return is zero at best, and more likely negative.
Of course they don’t address it. It’s just a simple fact that there are no guaranteed above-average returns. If there were, then everybody would be doing it.
When I first moved out on my own and got a checking/savings account, I was yielding a much higher interest rate, probably closer to 4% that first year. The very next year, they switched my account to this other version and started receiving about 0.5%. They knew what they got themselves into, I did not however since it was my first time out on my own.
But since I didn’t have any savings prior to that, I only took out student loans for schooling, but since my job pays so well, I am on the 10 year plan to pay them all off. Two years down! I know it isn’t fantastic, but it sure beats the 30 year plan most of my classmates are on.
Great article. I just wrote a similar article for seeking alpha in their premium content. Yours is better though!
I try fixed deposit accounts. Its possible to get 3 percent in a hundred days. But I wonder why nobody is mentioning it the author of the posts states you become a millionaire in 28 day when its even hard to double the money in a year?
And on the Idea of inflation, The interest made in a year on savings accounts is as well as junk dollars what more ten years when the money might have doubled then compounding cant be done using any savings method.
I suggest some paying HYIPs can perform up to par.
the only way this would work is if you can double the amount you have in the bank…so if you got 4,288 you have to put in 4,288 to make the 8k and so forth and so on…
Len,you should mention the law of 72’s.
The way interest is at most banks today,one would have to have the lifespan of Methuselah in order to double their original monies.
Agree!! Time and interest is really something that can make us rich!
Math is fun! Compound interest is really for those math lovers like us! So let’s do some computation.
Len,
The theory of compound interest is good. In the reality of the times we live in, though, maybe things aren’t so simple. As you’ve pointed out before, any gains must be weighed against the effects of inflation. A typical savings account, therefore, loses real value. The only place to take advantage of compound interest that beats inflation is the stock market. That’s a pretty risky investment these days and only getting riskier. So, what should we do with the lesson in this article? How do we turn it from something academic into something practical and useable?
Well, Jeff, sadly it applies more to the debt side of the equation than the saving side. Unfortunately, I believe we will have to wait for the world monetary system to undergo its inevitable reset before this will apply to savers again.
Compound interest “in reverse”, so to speak, is also interesting:
The interest part of an amortized mortgage payment is much larger than the principle in the early payments. The last payment includes very little interest.
I’m thinking how to convince other people to double your money everyday… or sell something which gives users enough quality and satisfaction to double your money every other day…. any ideas? 🙂
I love this. I havent experienced large amounts of compound interest but I hope to in the future. I currently have around 15K invested for retirement and waiting to see how this looks 7 years from now.
Compound interest is a strong motivator for most of us to invest our money. Leaving money at savings account that yield low interest is actually costing us money!
Albert Einstein did not make that statement about compound interest. The sentiment may be true but it is not from Einstein.
Um … which is why I wrote: “Legend has it …”
Len, Great article again, as usual! I have always thought there is a second financial force in the universe that may exceed the power of compounding interest. I refer to it as something like “having the discipline to save / invest every month coupled with the discipline to NEVER dip into the savings / investments until retirement”.
That works too!