What Is Compound Interest?

Professional sports is full of stories about young adults becoming millionaires overnight. Sadly, many also seem to go broke overnight. But one player is doing his part to teach his teammates about how to manage their money. Today’s lesson: compound interest.

In the clip below, you can see NFL player Carl Nassib explaining the power of compound interest to his teammates on the Cleveland Browns. Check it out (and excuse the beeps – the colorful language in the video is censored).

What Does Compound Interest Mean?

Compound interest itself is no secret, yet the video shows that even very wealthy people don’t understand it. Let’s break down what he explained in the video about compound interest.

First, to compound something means to augment it or intensify it.

Compound interest refers to the way money grows larger with interest. In corporate finance, there’s a distinction between simple interest and compound interest, but let’s keep things simple here and focus on what you need to know.

At a basic level, you need to understand that the more money you save and invest, the more you will gain in investment returns and interest. As your money grows, it will compound, or augment. The new growth will be based on a higher balance, which will mean you will passively gain more dollars every year.

Here’s An Example Of Compound Interest To Make It Clear

For this example we have two people. Let’s call them ‘Sam the Spender’ and ‘Sue the Saver’. Even though both have the same job and live together, ‘Sam the Spender’ only has $6,000 in the bank. ‘Sue the Saver’ on the other hand, has $11,000 in the bank.

Let’s assume that they don’t save any additional money, so they only contribute what they currently have. Remember that ‘Sam the Spender’ has $6,000 and ‘Sue the Saver’ has $11,000.

They are able to invest their money in stocks at an annual return of 5%. Let’s see what would happen if they forget about the money and don’t touch if for 10 years.

Compound interest table

compound interest chart

Initially, ‘Sam the Spender’ has $5,000 LESS than ‘Sue the Saver’. Since they didn’t add any additional money to their account, and both earn 5% annually, it would seem logical that after 10 years, ‘Sam the Spender’ would still have $5,000 less than ‘Sue the Saver’.

But that’s not what happens.

By the end of 10 years, ‘Sam the Spender’ has $7,757 FEWER dollars than ‘Sue the Saver’.

How can this be?

Compound interest!

The Power Of Compound Interest

What compound interest does, is base the new annual growth number on the larger balance. So 5% of a larger number will mean a larger amount of dollars are being added in investment growth.

We all understand that if a million dollars grows by 5%, the difference in dollars will be larger than if $10,000 grows by 5%.

This effect is further amplified if you save and invest additional dollars over time. You’ll be getting the double effect of your savings being added to the balance and the growth of your investments.

This seems rather simple and straightforward though, right? So why are we spending the time to show you this example?

Why Does Compound Interest Matter?

Compound interest matters because it’s one of the core principles to building wealth. Most people understand, at a basic level, that if they have more money they will make more money.

Yet lifestyle creep, lifestyle inflation, or the desire to keep up with the Joneses still leads people to spend on things they don’t need.

If you really sit down and understand how much a dollar today will be worth in 20 years, you may think twice before buying that extra thing you don’t need.

In our example above, a dollar today will be worth $1.55 at the end of the 10 year period. That means that $500 phone will actually cost you $775. Things will end up costing you a lot more than the sticker price once you realize the missed opportunity to invest and grow your money.

And no, we don’t think you should go and try to save every single penny and cheap out on everything. But if learning how to spend mindfully and use your money intentionally can help you be happier and save more. It’s a win-win.

After all, research shows that all of those physical products won’t bring you sustained long-term happiness.

Compound Interest

4 thoughts to “What Is Compound Interest?”

  1. This Might be a stupid question, but In order for me to reap CI benefits I have to invest in stock market? I have no clue how the stock market works. What do you suggest a beginner do? Where to start?
    I have money sitting in savings account not growing at all, the most savings account or CD’s do is give 2.05%.

  2. I understand compound interest but I don’t know where to put my money. I have a 401K, Roth IRA with Vanguard and a Betterment account. However, I am not sure I am doing the saving thing correctly or if I should invest my money somewhere else. I also have Ally but it only grows at 1.9%. Could you point me to a company I should be looking at? Thank you.

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