Did you know you can make money in your sleep? You can make money while you are lounging by the pool or while watching television. Even while on vacation! Sounds too good to be true doesn’t it?
As I typed that, I felt like I was typing the intro for some scammy late-night television infomercial. The crazy thing though is that you actually can make money while doing nothing. Compound interest is the secret way to earn money for doing nothing.
Now, you aren’t going to become a millionaire overnight through compound interest. You aren’t going to be become the world’s richest person by the end of the year either. But as you will see, compound interest is a solid strategy for growing your wealth. And you end up with a lot more money than you think, all thanks to compounding.
What Is Compound Interest
The goal is to see how easy it is become rich through compound interest. But first, we have to understand what compound interest is and how it works.
Compound interest is interest you earn not only on the money you save, but on the interest you earn as well. For example, let’s say you have $100 saved and are earning 5%. At the end of the first year, you have earned $5.13 in interest.
If you had only earned interest on your savings, the $100, then you would have earned $5 in interest for the year. But as you earned interest throughout the year, that interest also earned interest. The “extra” $0.13 you earned is the interest from the interest. Make sense?
At the end of the second year, still earning 5% interest, your original $100 is now worth $110.52.
If you do the quick math, you will see that in the second year, you earned $5.39 in interest.
How did this happen? You earned interest on your original $100, plus the $5.13 you earned last year. You also earn interest on interest you are earning this year.
Let’s take this example out 10 years. You would earn interest on your original $100 plus the interest from each of the 10 years.
This is the magic for how compound interest leads to wealth. You earn money not only on the money you save, but also on the money you are earning.
The Compounding Penny Test
To see if you master the concept of compound interest, let’s look at a scenario. I offer you one of the following options:
1) $1 million dollars in 30 days
2) the value of a penny doubling (compounding) a day for 30 days
You can either take $1 million dollars in 30 days. Or I will give you the value of a penny in 30 days assuming it doubles in value every day.
Which option will you choose? Most will take the $1 million. But is this the right choice? Let’s find out.
Below is a chart of the value of that penny doubling in value every day. You can see that by day 15, halfway through the experiment, you are only at $163.84. It’s looking like the $1 million dollars was the correct choice.
Now we move ahead to day 22. Still, our penny doubling every day is looking like a bad choice. We only have $20,971.52.
But in the end, wouldn’t you know, the penny doubling in value wins! You end up with $5,368,709.12 after 30 days.
So what does this have to do with compound interest? When you double your money every day, you are taking advantage of compound interest.
Instead of earning 5% interest annually, here you are earning 100% interest every day.
Now, understand that earning 100% interest is absurd and doing so every day is even crazier.
But it shows you how powerful compound interest is. So how do we go about using this superpower to our advantage?
Using Compound Interest To Build Wealth
How do we start taking advantage of the power of compound interest? Most people make the critical mistake of trying to earn 100% interest rate like in the penny test.
To have compound interest work to its greatest benefit for you, you need to do two things:
#1. Save as much as you can.
#2. Earn a decent interest rate.
Let’s talk about each of these and then get into some examples so you can understand the importance of both.
Save. Save. Save.
When it comes to saving, there are a lot of things you can do. The two major things are to cut your expenses and earn more money. But there are lots of things in each of these categories that you can do to beef up your savings.
First, you can set up an automatic transfer to a savings account. I use Capital One 360 for this reason. If you open an account, you’ll get a $25 bonus for using my referral code.
If you aren’t interested in opening an account with Capital One 360, then try out Digit. It is 100% free. It works by automatically transferring money for you, without you noticing. I’ve used the service for over a year now and have saved more than $1,000.
But transferring money to savings is just the tip of the iceberg. From there, you can look at cutting some expenses out of your budget. Can you reduce your cable package? I’m sure you don’t need 300+ channels. With other services like Apple TV, Fire TV and Sling, you can save money on cable.
Another option is your cell phone. Why spend over $100 a month when you can get the same thing for a fraction? I use Cricket. They use the same towers as AT&T.
I get unlimited calling and texts, and 2.5 GB of data each month. My cost? A cool $35. You read that right. If you sign up with them, they will give you $25 off your first month. That means you pay $15 for cell phone service for a month.
What about reducing the amount you spend eating out each month? I’m not asking you to be miserable and not have any fun. But there are some things you can cut back on or go without and still be happy.
Take some time to run through how you spend your money and see if there are some things you can go without or cut back on. I’m sure there are some things you can do without and not impact your daily life. The key is to make sure you save that money and not spend it.
Finally, you can look at earning some more income. If you get a raise, save the difference. For example, if your paycheck was $500 a week and is now $515, save that $15 and keep living on the $500. This guide will help you to get a raise at your current job or set you up for a nice salary increase if you switch jobs.
Another option is to do things on the side to make some extra money. Thanks to technology, it is easier than ever to make more money. You can take surveys, surf the net or even charge people to sing “happy birthday” to them. Your options for making money on the side are almost endless.
As you can see, you have many options when it comes to cutting expenses and earning more money. Let’s now look at the importance of your interest rate.
Understanding Interest Rates
While it would be great to have your money double every day, it is just not possible. Sadly, too many people still try to do it. They think if they just find the highest interest rate, they will get rich quick. Unfortunately they don’t understand the risks that come with such a high interest rate.
Remember, the higher the interest rate, the higher the risk you assume. This means losing the money you saved. So what are some good interest rates you can earn while not taking on too much risk?
For starters, there is your savings account and bank CDs. Unfortunately right now, you are going to be earning close to nothing interest on these. If you go with an online bank, you can get 1% on your savings but that is pushing it.
Your next option is the stock market. If you invest in a portfolio of low cost index funds, you can comfortably earn on average 8% per year.
Anything more than this, you are taking on great risk. Always remember that risk and return go hand in hand.
The investment that earns you 50% a year will grow money faster. But you also have a higher risk of losing all your money too.
I fell for this idea years ago.
I had some money to invest and trying to make a killing, I invested in a tech mutual fund that had been returning 60% a year. I put in $2,500 and by the end of the year, the fund lost 60%. My account now only had $1,000. It hurt a lot and reminded me how risk and return work.
I now invest in funds that track the market. Do I still lose money? Some years, but over the long-term, I have earned a decent return.
So let’s see the impact interest rates have on our saved money. Below is a chart. The left side shows you various saving amounts. The right side shows you how much interest you would earn in a year with a 1% interest rate and then an 8% interest rate. (I rounded out the cents to make it easier to follow.
There are two things to take notice here. First, when you have a large amount of money, earning 8% annually results in a nice return of your money.
For example, if you have $1 million saved and you earn 8%, you will make $80,000 for doing nothing!
Second, the amount of interest you earn on a large amount of savings with a smaller interest rate is a lot of money.
If you saved $1 million dollars, and it is earning just 1%, that is $10,000 a year. For most of us, this amount isn’t enough to live off of. But you can take less risk, earn a smaller return and make a decent amount of money. All thanks to compound interest.
For example, if you earned 3% on that $1 million, that is over $30,000 in interest. This is the beautiful thing about compound interest. Once you save a decent amount of money, you can earn a small interest rate and still make a lot of money.
Your Compound Interest Plan
So now you know that compound interest is the lazy man’s way to earn money. You also know when starting out, you need to focus on saving as much money as you can. Then you need to focus on the interest rate you earn. We are now going to put everything into action.
As I mentioned before, you start out saving as much money as you can. Do whatever you have to do, cut expenses and make more money, so that you can save as much as possible.
How much should you be saving? Depending on who you ask, you will get various numbers. I would suggest trying to save 40% of your income a year or more.
This might be a shock to some, but you can work up to this number. For example, if you have a 401k plan at work, set your contribution to 10%.
Next, set up an automatic transfer each month for another 10% of your income and you are already at 20%.
From there, focus on knocking down expenses and then find some ways to bring in more money.
Keep increasing the amount you save each year. Try to make a game out of it.
When you have 6-8 months of expenses saved up in a savings account, it is time to start investing in the stock market.
But to save you some time, I’ll narrow the list down for you here. If you you want everything done for you, Betterment is a good choice. Investing with them will get you 6 months free.
If you would rather handle things on your own, then Schwab is a great option. This link will give you $100 when you open up an account.
Finally, if you don’t want to pay outrageous trade commissions, there is Motif Investing. When you sign up with them, you can get $150 free.
Remember when investing, the goal is to get a decent return. This comes out to around 8%. Don’t try for home runs, as you will strike out. Earn a decent return and still sleep at night. I recommend you read this post for an outline on being successful in the stock market.
As you earn a nice return from your investments, you have to keep saving money. This will snowball the compounding process and allow you to grow your money much faster. For example, let’s say you saved $10,000 and put that into the stock market earning 8% per year. Each year, you also invest another $10,000. How much money do you have after 20 years?
After 20 years, you have over $500,000. But you can do better than this.
Let’s say you saved $10,000 and invested it for 20 years, earning 8% a year. But this time, you are able to save $20,000 more each year.
After 20 years, you have over $1.5 million dollars. So remember to save as much as you can and keep saving. And earn a decent interest rate to grow your wealth through compound interest with ease.
Compound interest is your best friend. You can grow wealthy by using compounding to your advantage. The trick though is to save as much as you can as well as not getting greedy.
Earn a solid return for your risk and in time, you will be rich. It won’t happen overnight and it won’t happen in a year. But 99% of people never become rich that quickly and the ones that do tend to end up broke just as fast.
Take your time and be smart with your spending and savings. Before you know it, the power of compounding will take off and you will see the impact of your work.
[Photo Credit: stevepb]