Albert Einstein reportedly said “compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
It must be tricky then, mustn’t it? Hard to get your head around?
No. Not at all. Actually it’s quite simple, both to understand and to apply.
But what’s it got to do with smarties anyway?
Take a few minutes to understand the power of compound interest and how to use it to change your life…
THE REAL SECRET TO WEALTH SERIES…
Lisa Weaver, CEO of MoneyTalk talks with Walter Munro, the Editor, about the power of compound interest.
WALTER — Aside from inheriting money or winning lotto, what wealthy people know is that there are really only two ways to create significant wealth.
LISA — Welcome to MoneyTalk. I’m Lisa Weaver and this is Walter Munro … and we want to tell you the real secret to achieving financial security.
WALTER — The first way to create wealth, the hard way, is to generate a capital event. That means selling something valuable… perhaps a business you have built up or real estate you’ve developed.
LISA — That’s not what we’re here to talk about today though, because creating that asset requires a massive amount of hard work and usually a lot of risk.
WALTER — …and often luck, too. The other way doesn’t involve huge effort or risk, or luck… or even skill.
It just requires patience and persistence.
LISA — The second way to create wealth is to use the amazing power of compound interest.
WALTER — Albert Einstein called compound interest the eighth wonder of the world and said “he who understands it earns it… he who doesn’t… pays it”
WALTER — It underlies everything in banking and finance so it’s vital to understand.
LISA — So how does it work? And how do you make it work for you?
WALTER — Well, really it’s just reinvesting your interest so that it earns interest too.
The magic ingredient… is time.
WALTER — Say some nice person gives you ten smarties.
You could just eat them… obviously.
But let’s say you could lend them to someone else and receive interest.
Let’s say you could invest 10 smarties and I receive one smartie at the end of the year as interest… an interest rate of 10% per annum.
…which you spend… yum. So every year you get to eat a smartie.
Three decades later, you’ve eaten 30 smarties and still have your original 10 left.
That’s simple interest… giving you 30 smarties over 30 years.
LISA — But what if you didn’t eat any of your interest? What if you reinvested it?
WALTER — This time, from the start of the second year, interest is calculated on 11 smarties rather than ten.
A year later it’s calculated on just over 12 smarties… and so on.
It doesn’t make that much difference at first but…
After those same 30 years I’d have earned…
…164 smarties instead of 30. That’s compound interest.
LISA — I’d just eat the 10 smarties to be honest, but with real money we’re talking about something that could change your life.
Here’s a more realistic example. Let’s say you have $10,000 in savings which you invest, earning 10% per annum.
WALTER — Now that may sound like a high rate, and you certainly can’t get it in a bank account, not at the moment, but it’s actually just an average long term return – and not from being particularly clever either. We’re talking about passive, set-and-forget investments – we’ll come back to how you can achieve that in the next video – I promise.
LISA — Okay so, back to simple interest for a moment. You force yourself to forget the $10,000. It’s not money any more, not in the spending sense. It’s capital now.
You’ve put it to work to earn you income, so every year you withdraw just the income – $1,000 – and you buy yourself a present… I’m thinking a gorgeous outfit…dress, shoes … even a new handbag…
WALTER — the latest gadget, maybe?
LISA — Anyway. The point is you get a lovely selfie present every year, but 40 years later you still have only $10,000 of savings – not something that’s going to give you any sort of retirement… but that’s simple interest for you.
WALTER — Or you could be really smart. You could ignore your little nest egg and forego your annual selfie present.
LISA — You re-invest your income so every year your balance grows, and the following years income increases… etc, etc, year after year.
And after 40 years — you have over $450,000!
WALTER –From a one-off, $10,000 saving to 450,000 grand.
Notice how important time is though. It took 10 years to earn the first $15,000 but by year 30 you’re earning over $15,000 every year.
That’s why we said the magic ingredient is time.
And that’s the amazing power of compound interest.
LISA — Watch the next video in the series to learn how compound interest can transform your lifestyle in retirement, even taking into account tedious things like costs, taxes and inflation.
WALTER — And in the next video, we’ll tell you how to earn that 10% per annum. See you soon.