This one is a bit different. I’m going to go a little deeper than usual on a specific topic, because it’s crazy important.
I want you to pay attention, too. Like seriously listen up. Even if you haven’t before. Even if this is the very first blog post you’re reading in this course. If, for some crazy reason, you can only pay attention to one topic and one topic only, make it this one.
Got it. You’re weirding me out, but I’ll pay attention. What’s so important?
Compound interest!
If you recall, in the last post, we learned about interest generally. As a reminder, interest is how banks and other people who lend people money, make money. Interest can be thought of as a ‘reward’ for taking the risk of lending to other people. Risk some money lending it to others? Interest is the reward for your trouble!
Right, the higher the risk, the higher the reward, the higher the interest. I remember.
Before moving onto the compound variety, let’s set ourselves up for success with a concrete example. Let’s say you lend someone $100 so they can, I don’t know, take their family to the movies. They agree to pay you back the $100 they borrowed in a week, plus $5 extra for your trouble.
That $5 is the interest, right?
That’s right! You made that money by taking a risk on that other person and lending them money so they could go to the movies. You risked some money, you made some money via interest in return. Easy right?
Now, you’ve had your eye on a sweet pack of Pokemon cards and you decide to go spend that $5 right away on those cards. Good call, you earned it! You get that new stack of Magikarps and you still have the original $100 you started this whole business with! You used your money to make money and then used that extra money to buy something you wanted, without using any of the money you started with.
And I earned that extra money without actually doing any work of my own!
That is a SUPER DUPER MEGA IMPORTANT POINT so I’ll repeat it: “You earned that extra money without actually doing any work of your own.” It was your money, your loan, that did the work to make that extra money for you. Imagine if you lent out even more money, like $1000. Now, in that same week, maybe you get $50 in interest back instead of just $5! Now you’re making real money, for doing essentially no work. Not a bad deal right?
Sure, but how am I supposed to come up with $1,000 in the first place? That’s a lot of money.
Start small! You’re right, $1,000 is a lot of money, but stay with me on this one. Remember that $5 in interest your money made you in our first example? What if you took that additional $5 and, instead of buying Pokemon cards with it, you lent out the interest too? Then the original money you lent out would be making money and the interest money you made would also be making money. Back to the example, you get your $105 back from your loan, and the next week you lend out all $105 (original $100 and the $5 interest) and the person you lend it to agrees to pay you $5.50 on it this time. You’re lending more money, so you should get more money back in return. After getting paid back, you now have $110.50! Lend all that out and maybe you make $6 in interest this time. Now you’re up to $116.50 from your original $100! On and on you can go with this lending and re-lending. Eventually you’ll get to that $1,000, $10,000, $1 million and so on. The sky’s the limit if you continue to lend wisely and keep re-lending the money your money makes.
I’m guessing this is the “compound interest” you mentioned earlier?
This is the compound interest I mentioned earlier. You are re-lending (usually called “reinvesting”) the interest you made on your loan and thereby making even more money in interest on top of the original loan AND the interest you already made on that loan. Your money is making you money, and the money your money made is making you even more money on top of that! This is an incredibly powerful tool and, by continually reinvesting your money and interest like this, the total amount of money you have snowballs bigger and bigger. It won’t make you a millionaire overnight, but given enough time and reinvestment, it will make you a millionaire eventually.
So compound interest needs time to work?
Yes, and this is why it’s important to start putting away and investing money as early and as often as you can, even if it’s just a little bit at a time. Over time, without you doing any work besides reinvesting the money (and that can be done automatically nowadays), compound interest will, on its own, make you wealthy. Not necessarily very fast! We’re talking years and decades, not days and weeks. The more time you give your money to work for you, the wealthier you will be.
If you want to see just how powerful compound interest is, there are a bunch of free compound interest calculators out there like this one from NerdWallet you can play around with. Check it out, play with the numbers, and see just how much money your money can make you, if properly invested. In the next post, we’ll dive into how you can start building that compound interest using savings accounts.
Thanks for reading.
Common Cents 