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What the Heck Is Compound Interest?

 

Welcome to Part IV of my Be Economically Savvy series.

Originally, this was supposed to be a three-part series. However, over the last few weeks, the words compound interest have kept popping up. From folks retiring and trying to figure out what to do with their money, to parents trying to save and explain why they can’t buy a new car just yet, I can’t seem to get away from the question “What the heck is compound interest?”

Bottom line – Compound interest is when you earn interest on interest.  The longer you allow your money to grow, the more money you will have at the end of your savings period.

Put the money you’ve saved in an interest-bearing account.  Then, let your money work for you.

Watch my video Compound Interest Explained: A Visual Explanation Without Math to learn more.

 

Transcript

>>TYWANQUILA: Hello, everyone. If you've been following my Order Your Life Blog, you know I write about finances and becoming economically savvy.

00:08

One topic that keeps coming up is compound interest.

Instead of writing a blog about it, I've decided to create a video explaining compound interest.

Keep in mind that this is a visual explanation.

There's no math.

No formulas.

I know some of you like that.

Instead, there are a lot of beautiful visuals so you can see how your money will grow in an interest-bearing account.

00:32

Before we get started, we need to define four terms.

These terms are principal, interest, simple interest, and compound interest.

Here are the definitions.

00:47

Principal is the money you originally put into your account.

That's your starting point.

Interest is the money that a bank, or other financial institution, pays you for leaving your money in their establishment.

Yes, people will pay you to leave your money with them.

We're going to discuss two types of interest.

01:13

Simple interest and compound interest.

Simple interest is the money you earn on your principal.

In contrast, compound interest is the money you earn on your principal and on your prior interest.

Compound interest is when you earn interest on interest.

It's called compound interest because the interest builds upon itself.

I know this sounds complicated.

So let's look at an example.

01:41

In this example, you'll be able to see the difference between simple interest and compound interest.

In this example, let's say you put $1,000 into your account at the beginning of the year.

This is your principal.

$1,000 is the money you start with, and we're going to call it principal.

02:04

The annual interest rate is 5%.

The bank will add interest to your account every month.

Therefore, interest is added monthly.

And finally, for this example, you won't add or take away any money for 12 months.

You're leaving your principal untouched for 12 months.

02:24

As a result, 12 months is your timeline.

Let's take a look at our graph and see what happens.

Here is our graph.

On the top of the graph, we have our legend.

No interest is in yellow.

Simple interest is in purple.

And compound interest is in green.

On the y-axis we have the amount of money you've earned.

Our timeline is on the x-axis.

In this case, our timeline is in months.

All right.

03:05

Now that we understand the graph, let's make some money.

03:14

For no interest, you have $1,000 at the beginning of the year and $1,000 at the end of the year. Nothing's changed.

With simple interest you have $1,000 at the beginning of the year and $1,050 at the end of the year.

Congratulations! You've earned $50.

With compound interest, you have $1,000 at the beginning of the year and $1,051.16 at the end of the year.

You earned $51.16.

03:54

That's $1,000 with no interest, $1,050 with simple interest, and $1,051.16 with compound interest.

The difference between your earnings with no interest and simple interest is $50.

The difference between your earnings with compound interest and your earnings

with simple interest is $1.16.

You have earned a little more money with compound interest.

Now I know $1.16 doesn't sound like much, but there is a way for you to earn

more money with compound interest.

04:42

It's time for a little Q&A for the curious.

So what will happen if you increase your timeline?

The short answer is you earn more money.

Let's see what happens when you allow your money to grow for a longer period of time.

05:02

Example 2.

So in this example, we have increased our timeline to 30 years.

That's 360 months.

As before, we'll begin with a principal of $1,000 and we will leave that money untouched for 30 years.

The annual interest rate is 5%.

Interest is added monthly.

And, as I mentioned, our new timeline – our increased timeline – is 30 years or 360 months.

Let's go to our graph.

With no interest, let's see how we do.

05:39

With no interest, you began with a thousand dollars and at the end of thirty years you still have a thousand dollars.

Surprise!

Nothing changed.

With simple interest, you have $1,000 at the beginning.

Let's go back.

06:09

There we go.

There's simple interest.

With simple interest you have $1,000 at the beginning and $2,500 after 360 months.

Let's see what we have with compound interest.

You have $1,000 at the beginning and $4,467.74 at the end of your timeline.

That's not bad for someone who started with a thousand dollars.

06:41

Let's recap.

So no interest.

You start with $1,000.

You end with $1,000.

That's an earning of zero.

With simple interest, you start with $1,000 and you end up with $2,500.

You've earned $1,500.

And finally, with compound interest, you end up with $4,467.74.

Congratulations! You have earned $3,467.74.

07:23

Here compound interest is clearly the winner.

As you can see, the longer your timeline, the more money you earn.

Well this is great.

But is there anything else that you can do to earn more interest?

What happens if you increase your principal?

07:42

Well again the short answer is you earn more money.

In our final example, we are going to see what happens when you increase your timeline and your principal.

Your principal has increased to $10,000.

Again we're leaving that $10,000 and we are not going to touch it until our timeline ends.

Annual interest rate is still 5%.

Interest added is still monthly and our timeline is still 360 months or 30 years.

Let's see what happens.

08:20

Well no interest.

You guessed it.

You start with 10,000.

You end with 10,000.

As usual, there is no change.

With simple interest, you begin with $10,000 and you end up with $25,000.

Finally, with compound interest, you began with the same $10,000 and after 30 years you have $44,677.44.

08:54

Recap.

No interest.

Start with ten thousand.

End with ten thousand.

Zero earnings.

For simple interest, you end up with $25,000 and that means you've earned $15,000.

09:09

And finally, with compound interest, our clear winner here, you can see that the more money you put in at the beginning, the more you end up with at the end.

And in the case of compound interest, you end up with $44,677.44.

Meaning you've earned $34,677.44 over the course of your timeline.

09:33

Imagine how much you can earn if your principal is even higher or if your timeline is longer.

That is the power of compound interest.

You let your money work for you and all you have to do is wait.

09:46

Here are today's take-home messages.

Firstly, compared to no interest and simple interest, you earn more money with compound interest.

And you can clearly see that with no interest, it's not beneficial to you at all.

So either choose simple interest or, if you can, if you have that option, compound interest.

Put your money in an interest-bearing account that earns you compound interest.

10:12

To earn even more money, there are three things that you can personally do.

You can increase your timeline.

You can increase your principal.

And, ideally, you can increase your timeline and your principal.

10:27

I made this video specifically for people who want to see compound interest, but they're not necessarily interested in the math behind the magic.

So if you're one of those people who really wants to see the math, feel free to contact me.

We can talk about formulas.

We can talk about compound interest.

We can talk about simple interest and I'd be happy to talk to you.

10:49

I want to thank you all for watching my visual explanation of compound interest.

And if you have questions, feel free to email me or contact me on social media.

You can also go to OrderYourLife.com to get the latest financial tips and economically savvy advice.

Thank you!

 

Have you read the other parts of my Be Economically Savvy series? 

Click the links below to see what you’ve missed.

Part I: Save Money on the Things You Already Buy

Part II: How Much Money Can I Make Using Apps?

Part III: Saving, the Dirty Word Nobody Wants to Hear

Part IV: What the Heck is Compound Interest?

 

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