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. In fact, it was none other than Albert Einstein — the true authority on this topic — who 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 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.
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 — I know, but just play along — 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; 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, compound growth is truly a double-edged lightsaber that cuts both ways.
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