Discover the magic of compound interest and why it's important for building wealth

Compound interest is interest calculated on the initial principal, which also includes all accumulated interest from previous periods. Generating "interest on interest" is known as the power of compound interest.

Albert Einstein once said:

Compound interest is the eighth wonder of the world and the greatest invention of mankind. Whomever understands it, earns it; he who doesn't, pays it.

While some people question whether the quote was actually from Einstein, the power of compound interest is unquestionable.

Albert Einstein

Benjamin Franklin said it best:

Money makes money. And the money that makes money, makes more money.

That is probably the simplest explanation of compound interest that exists.

Compound interest is the famous way that Warren Buffett made his fortune. Jeff Bezos, founder of Amazon and one of the richest men in the world, had a conversation with Warren Buffett and asked him:

• Jeff: Warren, your investment thesis is so simple, why doesn't everyone just copy you?

• Warren: Because nobody wants to get rich slowly.

Time to Double Your Investment (Rule of 72)

To be fair, compound interest is a wonderful thing when you're earning it. When it's accumulating as credit card debt interest, you probably agree with Einstein that it's the most powerful force in the universe.

When investing in the stock markets, real estate or other businesses, we talk about the potential for doubling our money and how soon that could happen.

If you are considering making an investment with a certain interest rate, you can use the rule of 72 to calculate how long it will take to double your money.

Say someone offers you the opportunity to invest in a property in exchange for a 10% interest rate on your loan, divide 72 by 10 and you get 7.2, which is the number of years it will take to double the value of your investment.

You can also use the rule of 72 in reverse. If an investment promises to double your money in three years, you can divide three by 72 to get the interest rate (or return in this case), which will be 24% on the investment (72/3 = 24%). The 24% return on the investment is high, which could mean that the investment is likely very risky as well.

That's the kind of math that amazed Einstein and Franklin, and shows the power of saving as much money as you can at the beginning of your career in a retirement account that in most countries does not pay annual taxes, so it can grow over time. Therefore, if you need to make sure you fall into the first category and not the second, use the rule of 72 as a guide.

How to Calculate Compound Interest

It's possible to use online calculators to calculate compound interest, such as the SEC website.

It's important to note that, as with any investment vehicle, nothing is guaranteed and there is always an element of risk assumed. In the following example, 8% was used as the estimated annual interest rate, as it is the average annual return of the S&P 500 over the last 40 years.

• Initial Investment: $1000

• Instrument: An ETF that tracks the S&P 500

• Monthly Contribution: $100

• Investment Time: 5 Years

• Estimated Interest Rate: 8%

• Frequency of Compound Interest: Monthly

The initial investment was $1000, plus the monthly contribution of $100 and the effect of compound interest will result in the investment account having $8,838.00 in just 5 years.

Compound Interest Starting at 20 Years Old

Compound interest uses time to our advantage. Let's assume a person is 20 years old and starts investing.

• Initial investment: $500

• Instrument: An ETF that tracks the S&P 500

• Monthly contribution: $200

• Investment time frame: 25 years

• Estimated interest rate: 8%

• Frequency of compound interest: Monthly

At 45 years old, you will have $193,875.00 assuming a monthly contribution of $200. As this example shows, it is always better to start early.

Having a longer investment horizon is important, as the effect of compound interest may not be obvious in the short term, but will accrue over time. While young people may not have a lot of money to invest, time is on their side, and they are in the best position to leverage compound interest to accumulate wealth.

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