Understanding this one financial concept can make you millions

What if I were to tell you that you could be a millionaire in ten years starting with $1,000, investing $100 a month, and getting a return on investment of 5% per month? Now what if I told you that just one year later you would have nearly $2,000,000? Welcome to the power of compounding interest. 

What is compounding interest?

If you have never heard of compounding interest before, it is one of the best ways to make your money work for you. So how does it work? The idea can be illustrated best through an old fable. There are two sons sitting in a hospital with their dying father. The father has amassed a great fortune throughout his life and tells his children that he has one final lesson for them. He tells them both that he will give them two options. He will give them a $1,000,000 check right now, or one penny now and double that for the next month. One son is incredibly excited and chooses the $1,000,000 check. He runs off and buys a new car, a new house, new clothes, and everything he wants. The second son gives his father a hug and chooses the option with the penny. 

By this point you probably have realized that I wouldn't be bringing it up if the $1,000,000 check was the better option. But how much better is the one penny? Well to solve that we need to use the compounding interest formula which is FV (Future value) = PV (Present value) * (1 + r (rate at which it increases)) ^ t (number of periods). Replacing the variables we would get the following equation: FV = .01 * (1+1)^30. In case you don't have a calculator, this equals $10,737,418.24. The child that chose to take one penny today instead of a $1,000,000 would end up having nearly eleven times the amount that his sibling received.

How does it work?

A lot of people have heard of compounding interest before, but how does it work, and how can you make it work for you? The fuel behind compounding interest is the r and t in the above equation, or the rate and time. Every time period you are basically investing a larger amount, and that larger amount increases based on the r. Let's take an easy example and say you have $10, and are going to get a 10% compounding interest return for five periods. When you start off you will have $10. One period later you will have $11. Then your $11 multiplied by 10% will give you $1.10, and so you will have $12.10, $13.31, $14.64, and $16.11 by the end of the fifth period. Because you are in essence reinvesting the money you earn, you are constantly multiplying your return by a higher balance, and in essence creating extra wealth.

Using the rate and time you can create a multiplier factor which can be multiplied by any starting balance. Simply take (1+r)^t to generate the amount that your beginning investment will multiply by at the end of the last time period. Then multiply that by whatever the beginning investment is to get the final value. For example, if I was able to get a 5% return for 10 periods it would be (1.05)^10 or 1.628895. I would then take the 1.628895 and multiply that by my starting balance.

How to take advantage now

So what does this mean for you? No matter how old you are, or how much money you have, you can start making compounding interest work for you, but the key is to do it as soon as you can. A twenty year old who invests $10,000 now and $1,000/yr with a 7% yearly return would have to invest $34,000 just ten years later to make up for the lost time.

One of the quickest and best ways to harness the power of compounding interest is through investing. Investments can range from the stock market, to loans, real estate, and even investing in specific people. A principle that you will find while evaluating investments is that there is an inverse relationship between risk and reward. Treasury bills (basically loaning the government money) are a very safe investment, but the returns will be small. Investing in cryptocurrencies on the other hand is very risky as prices in the market are very volatile, but some have experienced returns of over 10,000% in the past four months alone. 

Always make sure to evaluate your risk tolerance and what investments will work best for you. Throughout my future posts I will be delving into more financials concepts and providing you with resources that you can use in your every day life. The first of these resources is a very basic excel document I made to help you figure out what levels of wealth you can achieve through the power of compounding interest. In this excel document, you can change any of the cells highlighted in orange (input) and all of the other cells will flow through. To access this excel document, I uploaded it to this link - https://www.dropbox.com/s/mbvvfibwx0egssk/Compounding%20Interest%20Calculations.xlsx?dl=0.

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