Compound Interest will make you Rich, Healthy, Happy, and Wise
I remember it like it was yesterday. I was 22 years old, had a well-paying job, living in Buckhead Atlanta, and was having the time of my life. It was a Sunday morning and I was hungover from a night of partying. I was checking the mail and I opened up a letter I got from Chase. I opened it up and it showed my credit card bill. A whopping $20,000. My headache got ten times worse. On that Sunday morning, I was brought back to my freshman year in High School where my dad sat me down and taught me about Compound Interest.
Keep in mind I graduated from college with a Finance degree. I knew all the rules about Personal Finance. How you should spend less than you make, invest your money wisely, and pay off your credit card every month. It was time to make a change.
Over the next few months, I drastically cut out all the dumb shit I was buying (clothes, random tech gadgets, and way too many drinks at the bars to name a few). I paid off that credit card debt and decided that I will NEVER be in that type of situation again.
As I reflect on that time what really sticks out to me is that I took pride in being knowledgable about personal finance and investing. It was taught to me at a young age, I had a Finance degree, and I even worked in Finance! How could I fall into this debt trap? That's when I had an epiphany: If I knew so much about personal finance but was still making these terrible decisions, how did people who didn't know this stuff get by in life? Ever since then I've made it a personal mission to educate as many people as I can about personal finance and investing. This post is about one of those fundamental building blocks of Personal Finance: Compound Interest.
Compound Interest is one of the most important concepts you will ever learn. When my dad taught me this in high school, it became a fundamental building block for how I approached many aspects of life. It has not only helped me in finance and investing, but it has also shaped my thinking around Health, Relationships, and Intelligence. Compound interest is commonly discussed in Finance & Investing but it is so much more powerful.
So I'll break it down for you in this blog post. First, some terminology -- I'll use the term Compound Interest interchangeably with Compounding. We'll talk about how Compounding will make you rich, how it will help you live a healthy life, how you can be happy, and how to use it to be intelligent.
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” - Albert Einstein
Here's the textbook definition of Compound Interest from Investopedia: "Compound interest (or compounding interest) is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods."
That's somewhat technical. Here's how I think about it: Compound Interest is the interest that we calculate on our TOTAL Investment amount. It takes into account all of the gains that we've accumulated previously. This is different than Simple Interest, in which I would only receive interest in my investment amount for the year, but won't take into account all of the gains I've accumulated previously. This is best illustrated with an example:
Two people, Alice and Bob, both come to me with business propositions. Alice understands compound interest and Bob does not.
Alice says, "I'm going to invest $10,000 with you every year for the next ten years. And I want you to pay me 7% interest on the total value of my investment. So every year, you will pay me 7% on the total amount of money that you are managing for me."
Bob says, "I'm going to invest $10,000 with you every year for the next ten years. And I want you to pay me 7% interest on that $10,000 investment every year. You don't have to pay 7% interest on the total value of my investment. Just 7% on the $10,000 I give you every year.
Notice the key difference here: For Alice, I am paying 7% on the total value of her investment every year vs. for Bob I am simply paying 7% on the $10,000 he gives me every year." Let's see how this plays out for each of them after ten years:
As you can see, Alice makes a lot more money from her investment than Bob because her returns are COMPOUNDING on each other year after year. Notice how the growth rate every year is applied to Alice's TOTAL investment amount. She is able to take advantage of the gains that she receives every year.
As time goes on, Bob is getting 7% on $10,000 every year which is just $700 ever year. So, Bob's returns will grow linearly at $10,700 every year. After 10 years, he would've invested $100,000 and the total value of his portfolio would be $107,000 because he made $700 every year.
For Alice, she is getting 7% on the total value of her investment which becomes a much larger number. For example, after two years, Bob's total investment is $21,400. He put in $10,000 in Year 1 and made $700 and then he put in $10,000 in Year 2 and made $700 again for a total of $21,400. However, for Alice she put in $10,000 in Year 1 and made $700. But in the 2nd year when she put in an additional $10,000 we multiplied the 7% by her total investment amount which was $20,700, which equals $22,149. At the end of year 2 the difference is minimal of only $749. But as the years go by, the difference becomes much larger. For example, after 10 years, Alice has invested the same $100,000 that Bob has invested, however the total value of her portfolio is $147,836 versus Bob's total portfolio value of $107,000.
Be like Alice. Don't be like Bob.
The beauty of understanding this concept is that you realize what truly matters when understanding Compounding is TIME. It's about the amount of time in the market, not timing the market. The longer that you are letting your money work for you, the larger that this sum will grow. So start investing -- NOW!
Using Compounding to be Healthy, Happy, and Wise
Compound interest doesn't just apply to Finance. Every day in life, if we're improving ourself we are making "gains". Similar to finance, these gains will compound on each other.
Staying fit for a longer period of time as early in life as possible will give you better health benefits in the long run. If you begin working out and eating healthy at 20 years old and stay consistent with this routine for life, by the time you're 60 years old you are receiving the benefits of your health for the past 60 years. You're moving well, feeling good, and have high energy. Contrast this with the guy who began working out at 58 years old -- he probably doesn't feel as good since he only has two years of a healthy foundation he's working from.
Every day when I read a book, I am building upon knowledge that I have gained from all my previous reading. This base of knowledge continues to build and COMPOUND. This makes me wiser (I hope).
Want to be great? Just be 1% better.
Another way of looking at this is that you don't need to make drastic changes from the day you start building a good habit in Finance, Health, or any other aspect of life. You just need to get 1% better every day. If you get 1% better every day, you are going to receive the benefits of compounding because that 1% is compounding DAILY. Here's a visual representation from James Clear's post on Continuous Improvement:
Now begin to using this concept of Compounding everyday in your life and you will see how this is applicable to Wisdom, Happiness, Relationships, and so much more.
The way to be great? Just be consistently good.