How compound interest works
If you make an investment of $100 with an interest rate of 1% per month, after 1 month you will have $101. In month 2, if you were only using simple interest, you would have $102. But if you were using compound interest, you would have 102.01.
Yes, it looks small. But the power of compound interest really comes in over time. Check out the following data on how your investment would grow with regular interest and compound interest with an interest rate of 1% per month.
That got out of hand quickly! After 50 years, we have a total of $700 from our $100 investment when we use simple interest. But with compound interest, we would have $39,158.34! That difference is insane.
Early on in the life of your investment, 1% doesn’t make much of a difference. But over many many years, the multiplier becomes larger and larger. If we take a look at the math (trust me, it’s simple) behind the two types of interest, this trend becomes a lot clearer:
Regular interest = $100 * (1 + months * 0.01)
Compound interest = $100 * (1.01^months)
That exponential factor is what makes the biggest difference. It’s much more powerful than the multiplication.
Many people think that Warren Buffett’s yearly investing returns must be crazy! 1000% some say! But that’s not even remotely close. Many analysts quote Buffett’s average return over his life as roughly 20% per year. Considering that he’s 89 years old and has probably been using compound interest for a long time, 20% per year is plenty. Investing $100 over 50 years with Warren would have gotten you $910,043.81! So if you’re able to somehow average 20% a year, trust me, you’re doing quite well.
How to take advantage of compound interest
Now that we understand the power of compound interest, it’s time to put it to work. From the examples in the table, it’s easy to see how even an extra 1% can make a huge difference when compounded over time.
Our goal is now to take advantage of that 1%, or any other extra interest we can, however small. Take a second to think; there are probably quite a few places in your investments and daily spending where you can make a tiny bit of extra interest. Even if they’re small now, they’ll help grow your money bit by bit, which adds up big over the long term.
Here are a few to get you started:
Most banks with investing platforms will allow you to set up (just call in) an automatic reinvestment of your dividends. That is, whenever you earn dividends from your investments such as stocks, ETFs, or Mutual Funds, the dividend funds are used to automatically buy more of that same investment. If you bought some stock in Apple in 2020, you would earn a yearly dividend of 1.15%, split up over each quarter. So, you would be compounding your interest quarterly at a rate of 1.15 / 4 = 0.2875%. Remember, this all adds up! Some companies have dividends of 2%, 3%, 5%, even 8%, or 10% where you can really take advantage of compounding!
Invest any extra cash you have
After you establish an emergency fund to last you 6 months or more, and you’ve paid off all debts, the next financial question you should be asking yourself is: “how can I use my money to make more money?” Even if you have $100 laying around, don’t brush it off as insignificant! Invest it, wherever you can and feel comfortable doing.
If you don’t want to take on any risk, then a High Interest Savings Account (HISA) or a GIC will be a perfect choice as they can never lose money. The interest may be slightly lower, 1% to 2%, but as we’ve just seen those little gains add up quite quickly! If you’re still paying off your mortgage, then you can send most of your extra cash there. Your home is an investment and will increase in value over time.
Get a good credit card
The gurus on the internet might lead you to believe that all credit cards are evil. But that’s simply not true. Credit cards are a much better option than paying cash since many have a cashback or flight miles reward (if you like to travel). For example, a credit card may offer a 2% cash back after you spend $5,000. That’s a free 2% ($100) just for using a different card! And if you’re using the card for everyday purchases and bills, that $5,000 will be used up quite regularly.
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
— Albert Einstein
The Neatest Little Guide to Stock Market Investing is a great introduction to stock market investing if that’s something you’re into!