- Compound interest is the interest calculated on an initial amount, which includes all accumulated interest from previous periods of that initial amount.
- The rule of 72 is a simple and quick formula to determine how long it takes you to double your initial investment at a given interest rate.
- The money moves you make right out of school and in your 20s and 30s have a huge impact on your wealth as you age and could affect your possibility of becoming a millionaire one day
Did you know that the money moves you make right out of school and in your 20s and 30s have a huge impact on your wealth as you age and could affect your possibility of becoming a millionaire one day?
How, you ask? Well, Albert Einstein is thought to have once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” This simple statement carries a lot of truth and wisdom, and is actually the key to you achieving your dream of becoming a millionaire. Let me explain.
A lot of people delay starting to invest because of misconceptions of the amount of money you need to begin, some feel they are not ready, or think you need to have sufficient level of knowledge before embarking on your investment journey.
I, too, thought this way until I saw a graph that changed how I think about money (more below) and I finally understood how compound interest works. As you can imagine, I haven’t looked back since then.
As you are about to see, when it comes to investing, there’s no better time to act than the present. However, it is never too late to start, literally never. Why? Because of compound interest!
What is Compound Interest?
By now you have probably heard about the power of compound interest. This is because at the end of the day, compound interest will always be your best friend when it comes to investing. Simply put, compound interest is the interest calculated on an initial amount, which includes all accumulated interest from previous periods of that initial amount.
Here’s a quick example. Imagine you deposit $100 in a bank account which has an interest rate of 2%. At the end of the first year, you will have $102. After two years, this amount grows to $104.04 because interest was calculated on $102, after three years, the initial amount becomes $106.12 because interest was calculated on $104.04.
Still following along? After 20 years, the initial $100 would become $148.59, almost one and a half times the money you initially put in the account. So basically compound interest allows your money to grow at a faster pace.
Of course, compound interest can work in reserve as well. Ever wondered why if you missed your credit card payment, the fees charged on the balance you owe always increase? That’s because banks use compound interest to calculate fees so you end up paying interest on interest!
Which brings us to our next point, the Rule of 72.
Rule of 72
Essentially, the rule of 72 is a simple and quick formula to determine how long it takes you to double your initial investment at a given interest rate.
Years to Double Your Money = 72 ÷ Interest Rate
Here’s a quick example (brace yourself, math is coming). At an interest rate of 6%, an initial investment of $100 would take 72 ÷ 6 = 12 years to double.
This formula also makes it easy to understand how much you expect your investment to grow during a specific period or time horizon.
Imagine you have 36 years to invest money. At a 6% interest rate, that money would double every 12 years, giving you $200 in year 12. After that, it would take another 12 years for the $200 to become $400 in year 24. Finally, by the end of year 36, you would have $800. (Phew, the math..)
Okay, So How Do You Become a Millionaire?
You have probably heard that the early bird gets the worm. Nowhere is this truer than with investing.
Because of the magical powers of compound interest, the key to becoming a millionaire is to start investing early. The earlier you begin, the longer your money has a chance to grow!
Imagine these two scenarios:
- A 25-year-old invests $5,000 every year for 10 consecutive years. After age 34, no additional investments are made and the money is left to grow until the investor reaches age 65.
- A 35-year-old invests $5,000 every year for 30 consecutive years until retiring at age 65.
Who do you think will have more money at 65?
- The individual who started investing at 25 years old and made 10 total payments of $5,000 will end up with approximately $787,180 at age 65.
- The 35-year-old who made 30 total payments of $5,000 will end up with approximately $611,730 at age 65.
If you manage to invest more than $5000 a year, your total investment would surpass $1million by the time you’re 65!
This is the wonderful wonders of compound interest. So, what are you waiting for? Go and put that money to work!
Sold on the idea of making your money work for you but not sure where to begin investing? This is article is part of a series that explores how to become a millionaire. Check out my investing journey here. I do all the heavy-lifting for you so that you can decide which investment vehicles are right for your financial goals.