The Power of Compound Interest
Albert Einstein once said that compound interest was the most powerful force on earth.
What is compound interest?
In simple terms, compound interest is the effect of interest being earned, paid or on interest.
If you had £100 in the bank earning 7% interest per annum at the end of the year you would have £107. In year two, you are earning 7% on £105, not £100.
The Rule of 72
If you did not touch the interest or savings and the interest continued at 7% per annum how long would it be before your money doubled?
The answer is just over 10 years.
Look at it from another point of you, if you have a credit card debts rolling up at 20% per annum, how long would it be before your debt doubled in size? The answer is just over three years. However, let’s assume you are paying the minimum 2% off of your debt balance, and for the sake of this exercise we assume that effect is that you will be paying 18% on the debt. It would still only take four years before your debt has doubled in size. Furthermore, just paying the minimum payment on your balance would probably take decades before you could clear it.
I’ll give you a quick way to work out how long are some doubles based on an interest rate. It’s called the rule of 72.
If you divide the interest-rate that you are earning into 72 or take 72 and divide it by the interest-rate this will give you the approximate number of years will take to double.
In the above example, if you’re earning 7% per annum, seven into 72 is just over 10, therefore it will take just over 10 years before your money will double.
If I offered you the choice of either £1 million for one penny doubled every day for 28 days, which would you accept? The obvious answer is to take the £1 million, but you’d be wrong to take it, as one penny doubled and compounded over 28 days comes to £1,340,000. Amazing isn’t it. Day one, one penny, day two, two pennies and so on until day 27 it is £650000.
Word of the day
Compound interest and the Rule of 72.
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