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Albert Einstein once said: “The most powerful force in the universe is compound interest.” It may not be the first thing to comes to mind for many, but I think Mr. Theory of Relativity knew a thing or two about forces and it’d be wise to trust him on this one. For those of you unfamiliar with the concept of compound interest, it is interest that is paid on both the principal (an initial sum) and accrued interest (interest already accumulated on that sum).

For example, let’s say you deposited $1,000 into a savings account paying 5% a year. Let’s keep this simple and assume that the interest is paid once a year. The principal is the initial amount of $1,000 and the interest rate is 5%. After a period of one year, your account balance would be $1,000 + ($1,000 x 5%) = $1,000 + $50 = $1,050. After another year, your balance would be $1,050 + ($1,000 x 5%) = $1,102.50. Notice that the increase from the first year was $50 while the increase from the second year was $52.50. Each of these amounts is compound interest, but where did the additional $2.50 come from? Well, that was actually interest that was paid on the interest from the first year ($50 x 5% = $2.50). That, my friends, is the essence of compound interest. Earning interest on interest that has already accrued is key.

So what makes this simple concept so powerful? You might wonder how a few bucks here and there will make you rich. The answer is Time. Over time, money compounding year after year grows exponentially instead of linearly. Couple time with earning interest on interest and your initial investment will start snowballing until it’s an avalanche of wealth. To illustrate this, see the table below:

The table above displays the values broken down into 5-year intervals for some selected rates and assumes an initial investment of $10,000. Note that at 5% (the approximate interest rate you would earn by putting your money into a savings account), you would have $70,400 after 40 years. That’s not bad for just letting your money sit in a bank vault.

Every little percent counts though. If you look at the 6% column, after 40 years, the total is $102,857. That is 46% more than the figure for 5% even though 6 is only greater than 5 by 20%.

Now, how about 11%? (The average return of the stock market is often cited as 10 to 12%.) After 40 years, the total is $650,009 which is 823% greater than that for 5%. So, assuming that you were able to get an average return of 11% over 40 years, you would have $650k compared to just $70k if you had just put it in a bank. Given these facts, the stock market becomes very hard to ignore.

Just for fun, I included columns for 15% and 20% to show the totals for above average performance. For 15%, the total is about $2.6 million. Even after 40 years of inflation, that would be a decent nice chunk of change and a reasonable amount to retire comfortably. If you did even better than that and were able to achieve an average of 20% return over 40 years, the total would be a staggering $14.7 million. All this from $10,000. Looks like Einstein was definitely onto something.

To demonstrate the power of compound interest, I’d like to share an anecdote:

In 1626, Dutch settlers led by Peter Minuit reportedly bought Manhattan Island from the native people for some trinkets. Four centuries later, Manhattan is a bustling metropolis featuring some of the most expensive real estate on the planet. Some consider this one of the best real estate deals in history.

But for whom? Let’s take a step back and run the numbers. It is estimated that the trinkets exchanged for Manhattan were worth $24. Now if that $24 had been invested at 11%, 382 years later, the total would be $206 quintillion (quintillion = a million billion). Manhattan may be an expensive area, but it’s safe to say that it is not worth that much. In fact, all of the world’s wealth is just a drop in the bucket compared to $206 quintillion. Now it may appear that the Dutch got the shorter end of the stick, but that ridiculously large figure is based on some unrealistic assumptions. Not only would the Native Americans most likely not have been able to invest the proceeds in the financial markets, but also it would be exceedingly difficult to achieve average returns of 11% over 382 years.

Well, I hope you enjoyed this entry on compound interest. Hopefully, it convinced those skeptical of its bold claim that compound interest is, indeed, the most powerful force in the universe.

If you’re interested in learning more about compound interest, here are some resources that might be helpful:

Compound Interest article at Wikipedia: overview, formulas, and history

Compound Interest Calculator: Calculate future values based on initial principal, annual contributions, time, interest rate, and frequency of compounding