- While I have definitely made money mistakes in my life (who hasn’t?), I am fortunate that my parents provided me with a solid foundation of financial literacy.
- They’ve taught me many money lessons that have come in handy over the years, but there’s one thing they’ve done especially well to bring me home: the power of compound interest.
- I learned how compound interest can have a big impact on my net worth after making my first major purchase in high school – a Coach purse.
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Growing up at a time when the market was relatively volatile (the 1990s), it was important to learn good financial habits from an early age. Fortunately, my parents were there to help point me in the right direction, and they gave me a few words of wisdom that I will never forget.
But before I tell you about it, let me offer you a brief review of basic algebra. Do you remember the days when you thought about your homework on simple and compound interest? Did you think you would never need to use it in the real world? Think again.
Understanding 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 amount of capital you invest, the rate of return, and the investment period. This is the simple interest formula.
departs from mere self-interest in that it leaves additional mathematical leeway for multiple periods of composition and exponential growth.
For example, let’s say you want to invest $ 10,000 at an annual interest rate of 3%, compounded monthly for 20 years. How much money will you have made at the end of these two decades?
Well, let’s start with your capital of $ 10,000. This is where you need to start, and to know what you will 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 investment of $ 10,000 will have reached approximately $ 18,207.55 at an interest rate of 3%, which will have provided you with a return of over $ 8,207. Who couldn’t use this?
So what does this have to do with my parents? Their best financial advice 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 choice ever since, and over time the exponential growth is certainly starting to pay off.
How a Coach Handbag Taught Me My Biggest Financial Lesson
They really pushed this point at 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 don’t remember how much that bag cost, but for the sake of argument let’s say it was $ 200. My dad said something like, âHope you enjoy this $ 1,500 handbag! To which I replied at the age of 16: “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 purse, it would be worth more, a lot more, five, 10, 30 years from now than it is 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 things that contribute to a high interest payment are the amount of your principal, the interest rate, and the number of times the interest is compounded.
Of these, I would say the rate itself is less important than the total number of times dialed, because that number of times dialed is what defines the exponent in the mathematical relationship.
Despite this, 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 will be able to 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 them 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 up. Worse yet, I could put my money in a low interest savings account and never see anything accumulate.
With a basic understanding of the mathematics of compound interest as well as a familiarity with our banking system, I was fortunate to learn how to take advantage of high yield accounts and favorable interest at a very young age.
By investing early and understanding how I can effectively earn interest, I have been able to see my investments grow. If you haven’t had a chance to do it because you didn’t know how, now you know! You can thank my parents for this.