The most powerful force in the universe is compound interest. - Albert Einstein
Compound interest is a magical concept that can help you grow your wealth over time. It's the idea of earning interest on your interest, and it can make a significant difference in the long run.
In this article, I'll explain what compound interest is, how it works, and how you can use it to defeat inflation and maintain your purchasing power.
Examples of Compound Interest
Let's start with a simple example to illustrate the power of compound interest.
Imagine you have $1,000 in a bank account that pays 4% annual percentage yield (APY). After 12 months, you would earn $40 in interest, so your account would grow to $1,040.
If you leave that $1,040 in the account for another 12 months, you would earn an additional $41.60 in interest. That extra $1.60 comes from compounding - you're earning interest on the $40 you previously earned.
As you can see, the money grows faster over time due to compounding. But how do we calculate this?
Understanding Compound Interest Formula
The formula for compound interest is:
A = P(1 + r/n)^(nt)
Where:
- A = the total amount of money after n years, including interest.
- P = the principal amount (the initial amount of money).
- r = the annual nominal interest rate (in decimal form).
- n = the number of times that interest is compounded per year.
- t = the time the money is invested for in years.
Using our previous example:
- P = $1,000
- r = 0.04 (4% as a decimal)
- n = 1 (compounded annually)
- t = 2 (2 years)
Plugging these values into the formula gives us:
A = 1000(1 + 0.04/1)^(1*2)
A = 1000(1 + 0.04)^2
A = 1000(1.04)^2
A is approximately equal to 1000 multiplied by 1.0816.
A ≈ $1,040.74
So after two years at a 4% APY, your $1,000 would grow to approximately $1,040.74 due to compounding.
Now let's have some fun with compound interest!
Fun Experiment with Compound Interest
I'm going to present a fun experiment that I've seen many times before. It compares taking $10,000 a day for a month versus taking a penny that doubles each day for a month.
At first glance, it seems like taking $10,000 a day would be much better than taking a penny that doubles each day. However, let's see what happens when we do the math.
Taking $10,000 a day for 31 days would result in:
$10,000 * 31 = $310,000
Now let's see what happens when we take a penny and double it each day for 31 days:
Day 15: $8,192
Day 20: $5,242.88
Day 25: $167,772+
Day 30: $5.3 million+
Day 31: $10,737,418
As you can see from this fun experiment, compounding can be extremely powerful over time.
Three Levers to Boost Compounding Results
There are three levers you can pull to increase your compounding results over time:
Lever One: Higher Interest Rates
The first lever is increasing your interest rates over time. This could be through refinancing debt at lower rates or finding higher-yielding investments.
For example, if you were able to increase your interest rate from 4% to 5% on a million dollars, that would result in an additional $10,000 per year ($200k * .01).
Lever Two: Adding More Money Over Time
The second lever is adding more money over time. This could be through increasing your income or living below your means and saving more money.
For example, if you were able to add an additional $5k monthly to your million-dollar account at 4% interest for one year:
$5k * 12 months = $60k + ~$40k in interest = ~$100k added to your account
So instead of having just over a million dollars after one year at 4%, you'd have over $1.1 million by adding more money over time.
Lever Three: Patience
The third lever is patience - letting your money work for you over time without touching it.
For example, leaving a million dollars at 4% untouched for ten years would result in:
$200k * 10 years + ~$400k in interest = ~$1.48 million after ten years
By pulling these levers and being patient over time with your investments and savings accounts, you can significantly increase your compounded wealth.
Addressing Inflation and Investment Opportunities
Inflation's Impact on Compounding
One thing to keep in mind when using compound interest to defeat inflation is that inflation will eat away at your compounded wealth over time if not addressed properly.
For example:
- If inflation is running at an average of 3% per year and you're only earning an average of 2% per year on your investments/savings accounts - then yes - technically speaking - you're losing purchasing power each year due to inflation eating away at your compounded wealth.
To combat this issue - find investments that have higher returns than inflation rates so that you're not losing purchasing power each year due to inflation eating away at your compounded wealth.
Seeking Better Investment Opportunities
Another thing to keep in mind when using compound interest to defeat inflation is not withdrawing money unless there's a better investment opportunity out there with higher returns than what you're currently getting on your investments/savings accounts.
For example:
- If you're earning an average of 4% per year on your investments or savings accounts but then decide to withdraw some money because "you need it," technically speaking, you're forgoing potential future gains. There may not be other investment opportunities that offer higher returns than what you're currently earning on your investments or savings accounts.
So don't withdraw money unless there's a better investment opportunity out there with higher returns than what you're currently getting on your investments/savings accounts.
Conclusion and Call to Action
In conclusion - compound interest can be an extremely powerful tool when used correctly and wisely over time. It can help defeat inflation and maintain purchasing power as long as it's used correctly and wisely over time.
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