- While I’ve certainly made financial mistakes in my life (who hasn’t?), I’m lucky that my parents provided me with a solid foundation of financial knowledge.
- They’ve taught me many money lessons that have proven useful over the years, but there’s one thing they’ve nailed particularly well: the power of compound interest.
- I learned about the impact compound interest could have on my net worth after I made my first major purchase in high school – a Coach handbag.
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Growing up in a period when the market was relatively volatile (the 1990s), it was important to acquire good financial habits from an early age. Luckily my parents were there to help point me in the right direction and gave me some words of wisdom that I will never forget.
But before telling you about it, let me give you a brief overview of basic algebra. Do you remember the days when you pored over your homework on simple and compound interest? Did you think you would never need to use it in the real world? Think again.
Understand the math behind compound interest
To understand compound interest, we need to understand how it is calculated. The compound interest formula takes into account more information than just the principal amount you invest, the rate of return and the investment period. It’s the
departs from simple interest in that it allows additional mathematical leeway for multiple compounding periods and exponential growth.
For example, suppose you want to invest $10,000 at an annual interest rate of 3%, compounded monthly for 20 years. How much money will you have earned at the end of these two decades?
Well, let’s start with your principal of $10,000. That’s what you need to start with, and to know what you’ll get, we need to consider the combined effect of your interest rate divided by the number of times the interest is compounded per year (12, for monthly compounding), then increase it exponentially to the total number of times your interest is compounded.
This value would be 12 times a year for 20 years, or 240 times in total. At the end of those 20 years, your $10,000 investment will have grown to approximately $18,207.55 at 3% interest, giving you a return of over $8,207. Who couldn’t use it?
So what does this have to do with my parents? Their best financial advice for me was to invest early and then reap the benefits of compound interest. Choosing long-term gains over short-term spikes in my financial portfolio has been my favorite decision ever since, and over time the exponential growth is definitely starting to pay off.
How a Coach handbag taught me my biggest financial lesson
They really pushed that point home. I remember one time when I came home from the mall after making my first big purchase that I had saved up for: a Coach handbag. I can’t remember how much this bag cost, but for argument’s sake, let’s say it was $200. My dad said something like, “I hope you enjoy that $1,500 purse!” to which I, 16, replied, “Dadddddd, it didn’t cost that much, it was only $200!”
The point my dad was trying to make was that if I had invested that money instead of buying a handbag, it would be worth more, much more, in five, 10, 30 years than it is today today. It was a lesson that made sense to me once he showed me some math.
Play the long game
Of course, the three main elements that contribute to a high interest payment are the principal amount, the interest rate and the number of times the interest is compounded.
Of these, I would say that the rate itself is less important than the total number of times compounded, because that number of times compounded is what defines the exponent in the mathematical relationship.
Even so, I try to invest as much capital as possible in my high-yield savings accounts or stock portfolios, and then leave the investment there for as long as possible.
The more my interest increases, the more I can enjoy a higher return later. And also balancing that with using my money to enjoy the things I love now.
Invest your savings today and watch compound interest help it grow:
For me, it’s a lesson in patience and know-how. I could invest my lump sum and withdraw it after a few years, but what’s the point? Investments don’t increase much overnight; this is mathematically how exponential functions work. They need time to grow. Worse still, I could put my money in a low-interest savings account and never see anything accumulate.
With a basic understanding of the math of compound interest as well as a familiarity with our banking system, I was fortunate enough to learn how to take advantage of high yield accounts and favorable interest at a very young age.
By investing early and understanding how to earn interest efficiently, I have been able to watch my investments grow. If you haven’t had the chance to do it because you didn’t know how, now you know! You can thank my parents for that.
Want to see your money grow? Consider opening a brokerage account today and investing your money: