Chapter 11
How Money Grows - The Power of Compound Interest
How Money Grows - The Power of Compound Interest
The principles of compounding are easily found in nature and an understanding of the miracles achieved in nature allows us to understand how these same principles apply to us as we climb the money tree.
You see the beauty of nature is that it gives back so much more than we put in. When the farmer plants a pumpkin seed, he doesn't just get back one seed! Otherwise why would he bother? By planting a handful of seeds he may be able to harvest a truckload of pumpkins. Nature is very generous! Nature is programmed to be abundant! This same principle applies to our personal finances and indeed to everything we do, but first we need to get out into the fields and dig!
Have you ever heard the saying "Money breeds Money". Well it's absolutely true.
When you save money, the breeding cycle starts straight away. It may take some time to see results, but the process is definitely underway.
The rate at which your money grows is exponential. That means that one dollar becomes two, then the two dollars become four, then eight and so on. This happens because the growth occurs not only on the money you have invested but also on the interest you are earning. Here's an example:
Say you invest $1,000 and every year it increases in value by 6%, this is what happens:
Your investment $1,000
In the first year it grows by 6% 60
So now you have $1,060
In the next year it grows by 6% again, which is 64
Now you have $1,124
In the third year it grows by another 6%, which is 68
And now you have $1,192
Notice how the amount of interest you are earning is increasing each year even though the interest rate has not changed and although you have not added to your initial investment of $1,000. The $60 grew to $64 in the second and then $68 in the third year. You are earning interest on the interest. This is known as compound interest. Your money may also be said to be "compounding at 6% per year" or earning "6% compound interest".
Now as we all know, interest rates change from time to time and if for example the interest rate doubled to 12% do you think you would end up with twice as much money?
Let's take a look. We'll start with the same $1,000 initial investment and compound at the two different rates over a longer period this time.
at 6% at 12%
after 5 years you have $1,340 $ 1,761 which is 1.3 times as much
after 10 years you have $1,792 $ 3,101 which is 1.7 times as much
after 15 years you have $2,399 $ 5,469 which is 2.3 times as much
after 20 years you have $3,211 $ 9,638 which is 3 times as much
after 25 years you have $4,296 $16,986 which is 4 times as much
after 30 years you have $5,750 $29,935 which is 5.2 times as much
As you can see from this example, a doubling of the interest rate leads to much more than a doubling of your money the longer you let it work for you.
So far we have only looked at what happens if you make a once-only investment of $1,000. Now let’s look at how fast your money grows if you were to invest $1,000 every year at either 6% or 12% compound interest.
What you get the amount at 6% at 12% you contributed
After 5 years $ 5,904 $ 7,115 $ 5,000
After 10 years $13, 538 $17,881 $10,000
After 15 years $23,753 $37,866 $15,000
After 20 years $37,424 $73,085 $20,000
After 25 years $54,530 $135,152 $25,000
After 30 years $77,488 $244,535 $30,000
The power of compound interest is truly amazing isn't it? The important thing to understand about compound interest is that a little extra interest makes a BIG difference over time. The other thing is that with regular saving and investing you will climb the money tree even faster with the benefit of compound interest. You need to make your money work hard year after year. At first it may not seem worthwhile, however over time the rewards are enormous.
You see the beauty of nature is that it gives back so much more than we put in. When the farmer plants a pumpkin seed, he doesn't just get back one seed! Otherwise why would he bother? By planting a handful of seeds he may be able to harvest a truckload of pumpkins. Nature is very generous! Nature is programmed to be abundant! This same principle applies to our personal finances and indeed to everything we do, but first we need to get out into the fields and dig!
Have you ever heard the saying "Money breeds Money". Well it's absolutely true.
When you save money, the breeding cycle starts straight away. It may take some time to see results, but the process is definitely underway.
The rate at which your money grows is exponential. That means that one dollar becomes two, then the two dollars become four, then eight and so on. This happens because the growth occurs not only on the money you have invested but also on the interest you are earning. Here's an example:
Say you invest $1,000 and every year it increases in value by 6%, this is what happens:
Your investment $1,000
In the first year it grows by 6% 60
So now you have $1,060
In the next year it grows by 6% again, which is 64
Now you have $1,124
In the third year it grows by another 6%, which is 68
And now you have $1,192
Notice how the amount of interest you are earning is increasing each year even though the interest rate has not changed and although you have not added to your initial investment of $1,000. The $60 grew to $64 in the second and then $68 in the third year. You are earning interest on the interest. This is known as compound interest. Your money may also be said to be "compounding at 6% per year" or earning "6% compound interest".
Now as we all know, interest rates change from time to time and if for example the interest rate doubled to 12% do you think you would end up with twice as much money?
Let's take a look. We'll start with the same $1,000 initial investment and compound at the two different rates over a longer period this time.
at 6% at 12%
after 5 years you have $1,340 $ 1,761 which is 1.3 times as much
after 10 years you have $1,792 $ 3,101 which is 1.7 times as much
after 15 years you have $2,399 $ 5,469 which is 2.3 times as much
after 20 years you have $3,211 $ 9,638 which is 3 times as much
after 25 years you have $4,296 $16,986 which is 4 times as much
after 30 years you have $5,750 $29,935 which is 5.2 times as much
As you can see from this example, a doubling of the interest rate leads to much more than a doubling of your money the longer you let it work for you.
So far we have only looked at what happens if you make a once-only investment of $1,000. Now let’s look at how fast your money grows if you were to invest $1,000 every year at either 6% or 12% compound interest.
What you get the amount at 6% at 12% you contributed
After 5 years $ 5,904 $ 7,115 $ 5,000
After 10 years $13, 538 $17,881 $10,000
After 15 years $23,753 $37,866 $15,000
After 20 years $37,424 $73,085 $20,000
After 25 years $54,530 $135,152 $25,000
After 30 years $77,488 $244,535 $30,000
The power of compound interest is truly amazing isn't it? The important thing to understand about compound interest is that a little extra interest makes a BIG difference over time. The other thing is that with regular saving and investing you will climb the money tree even faster with the benefit of compound interest. You need to make your money work hard year after year. At first it may not seem worthwhile, however over time the rewards are enormous.
| Overview | Only You can Make You Rich | Earn the Right to be Wealthy | Knowledge and Actions | Understanding Money |
| Entrepreneurs and Home-based Businesses | Meaning of "Making Money" | Season to Sow, Season to Reap |
| Developing Your Wealthy Mindset | Don't Throw Your Money Away | Pay Yourself First | How Money Grows |
| Teaching Your Children | Top 10 for Children | Top 10 Steps | Your Next Step |
| Entrepreneurs and Home-based Businesses | Meaning of "Making Money" | Season to Sow, Season to Reap |
| Developing Your Wealthy Mindset | Don't Throw Your Money Away | Pay Yourself First | How Money Grows |
| Teaching Your Children | Top 10 for Children | Top 10 Steps | Your Next Step |
