Interest Can Be Interesting
Interest is your friend; interest received from an investment is one of the greatest ways to earn passive income. April is Financial Literacy Month, and since interest is one of the paramount concepts of financial literacy, a few words about interest can be a valuable lesson, which will help you for life.
A Simple Lesson on How Interest Works
It’s amazing so many folks don’t know how interest works. It’s nothing to be ashamed of because many people are in the same boat. Here’s an example that will explain how interest works:
If you have $100, there are two options you can choose from — either spend it or save it. You decide not to spend it, but you don’t feel comfortable handing it over to someone else.
You could hide it under your bed. In a few years, you could look under your bed and you’d still have $100, unless someone found out about the $100 and heisted it. During that period you didn’t have use of your money; however, if you lend it to someone else, they would pay you interest for their use of your money.
Furthermore, you probably wouldn’t loan money without gaining some kind of payment; that payment is called interest. So, you decide you will charge four percent for each year that you allow someone to use your money. At the end of one year your money will have earned $4.00. This is slightly better than keeping it under your bed.
As a side-note, when you do retrieve your $100 from under your bed, you’ll quickly discover it won’t buy the same amount of stuff it could have when you first stashed it there. This is called inflation, and inflation literally eats away at your money.
How Interest Does the Heavy Lifting for You
What if in the above scenario you lend your money for more than a year? As we noted, you would have $104 at the end of the first year, then that $104 would earn four percent interest for a total $108.16 by the end of the second year. The $0.16 comes from earning interest on the $104, not just $100. Okay, so not a lot more, but that’s because we’ve only “invested” $100. Imagine if we invested $10,000, then after two years we’d have $10,816.
This is the magic of compounding, and compound interest does the heavy lifting. Albert Einstein said, “Compound interest is the most powerful force in the universe.” This is what interest does for you when you’re investing.
Time is the Greatest Component
Now that we understand compound interest, let’s see what the factor of time does to it; the more time you have, the more you’re going to earn.
Let’s take two hypothetical people: Jane and Nancy. Both Jane and Nancy just graduated from college and are both 22 years old.
Jane starts saving $2,000 a year and invests it at eight percent. Okay, eight percent is a little high these days, but the Dow Jones Industrial average has returned over 11 percent since 1929. Jane saves this $2,000 for nine years for a total of $18,000, earns eight percent for those nine years, stops saving money at that point, and lets her savings continue to earn at eight percent for the next 35 years until she’s 65.
Nancy, however, doesn’t begin to save until she’s 30, the same year Jane stopped saving. She also saves $2,000 a year, but she saves it for 35 years until she’s 65, saving a total of $70,000, which is almost four times what Jane saved. Like Jane, Nancy also earns eight percent interest each year.
When Jane and Nancy reach 65, Jane, who only saved $18,000, will have nearly $580,000. Nancy, however, who saved $70,000, will only have $470,000! Time makes all the difference.
Compound interest works, and it is time that it is the greatest component. Start early!
The information in this article is provided for education and informational purposes only, without any express or implied warranty of any kind, including warranties of accuracy, completeness or fitness for any particular purpose. The information in this article is not intended to be and does not constitute financial or any other advice. The information in this article is general in nature and is not specific to you the user or anyone else.