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What is the Power of Compound Interest?

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”    -Albert Einstein

Albert Einstein understood the power of compound interest, and understood it well enough to call it the eighth wonder of the world. If a man as smart as Einstein gave it that respect, perhaps you should too. Why? Well, that’s the purpose of this article. I will explain the what, I will explain the why, and I will explain the how.

I will begin with general compound interest, and then I will explain how it works through dividend investing. I will be utilizing the Dividend Reinvestment Plan (DRIP) calculator to determine approximately how much money you would make if you started compounding now, or if you waited. The results may shock you!

What is Compound Interest?

I’m sure you are wondering: How is it the eighth wonder of the world, if I don’t even know what it is? Compound interest is interest calculated on the initial principal.

This basically means that when you are collecting simple interest on something, if the interest is added to the new amount every year, you are now using compound interest.

Let’s give an example.

Simple Interest Scenario: You lend $10,000 to one of your friends with simple interest of 5%. This means that every year, your friend will owe 5% of $10,000 in interest. Multiply 10,000 x 0.05, then x the amount of years. Let’s say 10 years. He would have paid a total of $15000, which is $5000 of interest that you collected as profit.

Compound Interest Scenario: Same situation, except it is with 5% compound interest. This means that instead of paying 5% of $10,000 for the years going on, you pay 5% of the new amount. So the first year would be $500.

The second year would be interest on $10,500. Now, the equation would be 10,500 x .05, which is 525. We now add 525 to the equation for the third year, and so on. The interest compounds, and begins a snowball effect that grows HUGE.

Typically, you will only find simple interest loans.

However, compound interest is very prevalent in dividend investing, and the snowball effect is easily seen.

Here we will compare 15 years of investing with and without compound interest, using AT&T Stock. Please note that the snowball effect typically doesn’t start until at least a couple decades down the road.

 

In the pictures above, we are evaluating the compound interest potential if you were to invest $5000 in AT&T stock for 15 years. Neither result is very good, because there hasn’t been a consistent addition of funds towards the portfolio, and also it had only been 15 years to truly see the potential of compound interest.

However, which side looks more attractive?

The right side obviously looks more attractive, because you reinvested the dividends you received, and put them back into the stock.

Don’t view reinvesting as putting more money into the stock, because you would never have received the money if it wasn’t for the dividend. View it as a reward from the company, because they hope you invest more into their company.

On the left, without compound interest and you keeping your dividend money, your end balance in the portfolio remains $5000 (assuming the share price stays the same). On the right, since you reinvested the dividends you received and took advantage of compound interest, you will end up with approximately $13298.

Imagine this on a larger scale. Big difference!

Now, the number you see under “Dividends” is the amount of money you get from your dividends annually. As you can see, on the left after 15 years of investing in AT&T, you are only getting $412 annually. On the right, after reinvesting your dividends, you are receiving $948 annually. Neither is very much, but that is because of the little amount invested.

If you put away a certain amount of funds each month, you will receive a HUGE amount from dividends every year. I will discuss this later in the article, but for now, see that you are receiving over double the amount of dividends per year, with only $5000 invested.

What is the Profit Potential of Compound Interest?

Boy, oh boy. The profit potential of compound interest is ASTOUNDING, and I’m about to show you why.

This is a chart of years 16-40 with the same scenario as before with NO compound interest. As you can see, the end balance is the same as it was 40 years ago. $5000, because nothing has been added. What’s worse, is your annual dividend is only $693, after 40 YEARS of investing.

Here is the same scenario as before WITH compound interest, for years 16-40. This when the magic happens.

As you can see, your end balance is now $142,076. You have been reinvesting your dividends and they have compounded. You are now getting $15,644 annually from your initial investment of $5000. Do you see now? You turned $5000 into $142,076, and are still collecting $15,644 every year, and if you continue the process, it will only go up.

There are other ways to increase the amount of dividends you get exponentially, and I will discuss these ways in later articles. You could potentially reach $142,076 a year in dividends, not just your portfolio value!

Make your own calculations!

There are many DRIP calculators out there, but the one I use is here: https://www.hughcalc.org/drip.php

Dividends are generally taxed until you have owned the stock for one year, then it moves to the “qualified dividend” category. It is still taxed, but on a lesser scale.

Conclusion

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” -Albert Einstein

Compound interest is the magic of investing. Many have described it as the most wondrous part of the stock market. I hope you understand today what compound interest is, the power it possesses.

If you have any questions or concerns, let me know in the comments!

15 thoughts on “What is the Power of Compound Interest?

  1. Great explanation of compound interest! It’s a great opportunity to invest now…I should have started in my early twenties but I got wiser in my late twenties instead. To be honest, that delay cost me there over $1 million dollars! Onward and upwards I suppose. I appreciate your example as well. It illustrated how compound interest works very well. Thanks for your post!

  2. Wow. The difference is impressive as more time is added. I wish I had understood this when I was younger and taken advantage of the benefits that a regular savings program would have delivered to me now in my later years. I guess it is never too late to begin investing, but with fewer years left to live, the benefits will not be so great.
    I imaging different countries tax these investments at different rates? I’m not from the States so will have to look into my own countries tax policies regarding profits on investments to see how much ‘damage’ they will do to the dividends I could potentially receive.
    Thanks for sharing. I look forward to learning more from your website.

  3. Wow, I really learned something here and I didn’t have a clue about it before. I guess that means I will be one of the ones who ends up paying it ha ha.
    I can see how compound interest could be the eighth wonder of the world, especially when you understand mathematics like Einstein did. You’ve definitely given m food for thought when it comes to investing money. Thanks

  4. I was always interested in compound interest but it was so hard to understand that I gave up trying to learn more.
    You made it clearer to me with the loan examples, but after that part, I got lost. It’s still as complicated as I imagined and I think I just am not skilled for that particular domain of expertise.
    But you seem to be an expert! What studies did you follow?

    1. I am a current Business Administration Major, but honestly I haven’t really heard much about investing in there. Most of my knowledge comes from lots of late nights and early mornings, this is something I am truly passionate with. I continually research this and never get bored, because the opportunities are truly endless with what you can do!

      You don’t need a degree to be a good investor, you have the internet! Seperate the real from the fake, don’t fully trust one specific person. I would look at how many different people invest, take the knowledge and then make your own formula.

  5. Wow – very interesting concept! Thanks for breaking this down simply for those of us who don’t know a lot about it. I vaguely remember learning about compound interest in my finance class in high school but that was many years ago! Cool to refresh my memory. Looking at that chart – compound interest very well may be the 8th wonder of the world!

  6. Hitting the nail on the head right there with what is nicknamed “Kennedy Accounts” reinvesting and buying more stock in a company with the dividends gained. In all honesty, with a solid company like AT&T, there is no real lose situation – is the value of the stock drops in one year you get to buy more shares with your money if the value increases you get to buy less, thus it can be said even in a bit of down turn you can still benefit by having more shares.

  7. Compound interest sounds like a great way to lend money. Does the same principle apply when borrowing money from a bank? It seems you have some great expertise on this topic, you must have a background in this type of industry.

    I am always looking for new ways to make money, would compound interest also work when investing or starting a savings account?

    1. Typically banks use simple interest, lucky for us. Because if you take out a loan at a 5% interest rate, you will continue paying the 5% interest each month on the same value. You will have the same amount each month as a minimum payment. If the bank was going to compound because interest would multiply extraordinarily.

      Compound interest would work with investing elsewhere and a savings account! Although I don’t recommend using compound interest in a savings account, I would recommend putting your money elsewhere because you won’t experience any growth in your savings account besides the small amount of interest you earn each year.

  8. Hi there

    Your blog is very informative and I can clearly see that you have extensive knowledge and skill in this area. I particularly liked your reference to Einstein and as a teacher I referred to Einstein continually. He also said “I do not teach anyone, I only provide the environment in which they can learn”. You have definitely done that!

    Being in local government I do understand a little about compound interest, but I’m a bit naive when it comes to my personal finances. I had an initial loan of £8,000, over 5 years which is now down to £4,000, with approximately 1.5 years left on the initial loan. Would I be better off paying it off before the end of the loan term or keeping it for the remaining 1.5 years?

    1. It depends on the type of loan, and what strategy you are taking. In real estate, there is a strategy where you buy properties and rent them out to pay the mortgage, and a 30-year loan is much more attractive than paying it off faster because the rent can be more than the mortgage payment.

      If it is not a loan that is producing positive cash flow, then pay it off as fast as possible. The faster you pay it off, the less interest you pay.

  9. Your blog is very informative and I can clearly see that you have extensive knowledge and skill in this area. I particularly liked your reference to Einstein and as a teacher I referred to Einstein continually. He also said “I do not teach anyone, I only provide the environment in which they can learn”. You have definitely done that!

    Being in local government I do understand a little about compound interest, but I’m a bit naive when it comes to my personal finances. I had an initial loan of £8,000, over 5 years which is now down to £4,000, with approximately 1.5 years left on the initial loan. Would I be better off paying it off before the end of the loan term or keeping it for the remaining 1.5 years?

  10. Great post! I remember learning about compound interest after reading the book “The Wealthy Barber”. However, I did not have the money to invest at the time.

    Does it take 40 years to achieve good results or can you achieve reasonable results in 20? Or does the compounding only come into effect after a number of years?

    1. You can achieve good results in 20 years, even 15 with dividend stocks, IF you put a decent-sized monthly allowance towards it to help speed up the process. Also, investing in individual stocks will typically produce faster results than an index or mutual fund.

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