Compound Interest Formula – The Magic Formula for Becoming Rich and Building Wealth

When it comes to becoming rich / building wealth and the importance of regular saving and investing, you simply can’t afford not to talk about the power of compound interest. You know, I’m not sure if you can get rich quick (unless your definition of quick is 10 years or so); however, if that is your goal, then Compound Interest is the magic bullet of your savings and investing strategy.

Compound Interest - The 8th Wonder of the World

Albert Einstein famously referred to it as the 8th Wonder of the World and even went as far as saying that “the most powerful force in the universe is compound interest”. Einstein, you could say, was smarter than the average bear! ...so if he thought that there’s got to be something behind what he called the “greatest mathematical discovery of all time”.

For something so powerful, the maths behind compound interest is truly very simple. It is just interest earned on top of principal and interest i.e. interest accruing not only on the initial principal deposit you invested but also on the accumulated interest over time. This creates a snowball effect so that, as your capital rolls down the hill, it gathers more and more interest until you end up with a very large snowball indeed.

The really great thing about compound interest is you don’t have to do a crash-course in momentum stock trading or leveraged property investing to avail of this wonderful little financial miracle. Compound growth is available to EVERYONE the day you make a decision to utilize it i.e. the day you start saving and investing.

The Magic Formula!

Where the interest is compounded once a year then the Compound Interest Formula is: A = P(1 + R)Y whereby:
A = the accumulated amount i.e. how much money you've accumulated after n years, including interest.
P = the principal (the money you start with, your first deposit)
R = the rate of interest (AER) as a decimal (8% means = .08)
Y = the number of years you leave it on deposit

The Two Levers of Compound Interest: Frequency & Time

1. Frequency (or Interval)

In the above example we are simply compounding annually. But some savings and investments may compound quarterly or even monthly. So, it’s important to find this out in advance from the financial institution or broker. The frequency with which returns are compounded is particularly important when investing in Bonds. The following shows the difference in how the formula is calculated.
Quarterly Compounding = P (1 + R/4)4
Monthly Compounding = P (1 + R/12)12

The more frequent the interval of compounding is, the greater the impact on compound growth. However, it’s worth noting that although frequency is an important lever in the impact of compounding on the future value of a savings or investment vehicle, it is not as impactful as the term i.e. length of time (plus the compounding frequency "lever" is subject to the law of diminishing returns over time).

2. Time (i.e. the Term)

Compounding exerts its most dramatic effect (for a given interest rate) when the term is extended. In other words, the longer an amount is subject to compounding, the greater the effect.

If you invested $10,000, using the above formula, compounding interest at 8% per annum, over 10 years only, the future value would be $12,597. However, taking the same principal sum and interest rate, but compounding over 25 years, the future value would be $21,589! So, as you can see, the effect of term length is remarkable: the original sum of $10,000 doubles in less than 10 years and increases more than seven fold in 25 years.

How to Guarantee You’ll Become a Millionaire

If you are a long-term convert to the habit of saving and investing, then you will have no doubt discovered that compound interest is your long-term best friend on the road to wealth creation.

The best thing about compound interest is that it is your money working for you rather than the other way round. Pocket change can literally turn into millions over 20 or 30 years. Did you know that if you invested just $5,000 per year at an average return of 7% from the age of 25 you’d be a millionaire by the time you hit 65. Ok, so inflation would eat away at the real value of those million dollars after 40 years but it proves the point that over time, regular saving of quite small amounts can build up an astonishing sum of money.

The secret to reaping the benefits of compound interest is:

1. Saving and/or Investing a regular amount of money each month.
2. Leaving you money invested for the long-term.
3. Reinvesting your gains (interest), again and again.

Conclusion:

So, compound interest allows you to get rich slowly over time but you can speed up this process and get rich quicker by pulling on the two levers of frequency and time. Of course, maximising your interest rate by choosing the right investment vehicle in the first instance is also a big factor. However, the key take-home message in all of this is, leaving aside interest rate, the amount of capital (principal) you start with is not nearly as important as time i.e. getting started early. Remember, the great thing about compound growth is that this “magic formula” is available to EVERYONE i.e. YOU, the day you make a decision to utilize it!