Compound Interest: Eighth Wonder of the World

You may all know about the seven wonders of the world, But have you even heard about the Eighth wonder that exists? Yes! The compound interest is highly considered as the eighth wonder of the world.

Albert Einstein once said that “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pay it.” At beginning this quote might seem like a bit exaggeration but the math behind it shows that it is not.

So, What is Compound Interest ?

In simple words compound interest is when you earn interest in both the money you’ve saved and the interest you earn.

Compound Interest is the method of calculating interest any given amount assuming that the interest earned each period is added to the principle. Hence, you receive not only interest on your principle amount but also the added interest each year. In the finance industry compound interest is often referred by the world magic interest as it is considered one of the most fundamental wealth building ways.

Why does Compound Interest considered as a greater force?

When interest rates still existed, money in a bank account would overall get a 5% interest rate on it. This means that leaving a thousand dollars in a savings account was rewarded with a 50 dollar interest rate.

This is Great, isn’t it? Getting a reward for just letting money sit in a bank account risk free!

Next year, when the person just let the 50 dollars sit on the bank account, the institution rewarded 1,050 dollars with a 5 % interest rate. As a result, 52.50 dollars are added to the amount which then shows 1,102.50 dollars.

Prominent isn’t it? And the process repeats unless the person withdraws the money.

Negative compounding – how does it happen?

Similar to positive compounding that happens when you invest your money, you can also suffer from the consequences of negative compounding. An example is when you get a loan and do not repay it for extended periods. The larger the duration of non-payment, the exponential will be the overall interest charged on loan. The higher the rate of the loan, the greater is the impact of negative compounding.

That is why you should try and save yourself from personal loans and credit cards. Because you don’t know how soon the negative compounding effect can make the outstanding amount balloon into an unmanageable amount. Apart from this, delay in repayment also affects your credit score.

This economic principle also exists in the stock market and real estate. Great companies grow revenues and profits over time, which increases the price. Real estate produces rental fees for the landlord and also appreciates.

Both are possibilities for everybody to create enough wealth to live a relaxed lifestyle.

gokila

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