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How Compound Interest Works | Learn How To Make Thousands

This is what Albert Einstein had to stay about compound interest.

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.

Albert Einstein

So what’s so wonderful about it? What do we need to understand?

Here’s an example of compound interest working it magic.

You make an initial investment of $20,000. Over 20 years, you contribute $500 each month. At the of 20 years, you have $284,669.80

You contribute a total of $130,000 (green line) but you end up with $284,669.80 (blue line). Pretty good right?

Your profit turns out to be $155,000. That’s like getting a house for free!

This chart clearly explains that compound interest is good and truly a wonder as Albert Einstein describes it.

what is compound interest?

This is the Merriam-Webster definition of compound interest.

Does this definition make sense to you?

If it doesn’t, don’t worry, most definitions don’t make sense until you hear it used in a sentence or see an example.

Think of compound interest as exponential vs linear growth.

Here’s the difference between exponential and linear growth.

exponential growth

linear growth

Both charts start at $10,000. All that was invested was $10,000. After 20 years, one ends with $46,609.57 the other with $26,000.

Which chart would you rather have your money in?

So how does money grow exponentially? It grows exponentially because interest is calculated on a number that continues to grow year after year. The higher the number, the more interest.

In the tables above, you see side by side compound interest vs regular interest.

In the compound interest table, the amount in the compound interest column continues to increase year after year. That’s because interest is calculated on the previous year’s balance. The higher the number, the more interest. And the number (or balance) always grows.

You can also think of it as a snowball coming down a hill. The further it goes down, the more snow it accumulates and the bigger it gets.

In the regular interest table, the amount in the regular interest column stays the same. It stays the same because interest is always calculated on the initial investment of $10,000. Interest will always be $10,000×0.08%.

If you can’t define it or explain it, don’t worry, you’re never going to be quizzed on the definition.

At the end of the day, all you have to understand is this; compound interest helps you make thousands and thousands of dollars for free.

The secret is waiting and just seeing your money go up exponentially year after year.

How To Calculate Compound Interest

Use the from investor.gov to calculate compound interest. It’s really easy to follow and you get your results in seconds.

When you calculate compound interest, you’ll have to enter an estimated interest rate. Most people reference the average annual return of the S&P 500 market index. The S&P 500 return has been about 10% over the last 30 years.

I usually enter an estimated interest rate of 8%. Market returns fluctuate (go up and down) and are never consistent so to be on the “safe side”. I enter an 8% interest rate.

If you’re feeling ambitious, the compound interest formula is below.

  • A = final amount
  • P = initial principal balance
  • r = interest rate
  • n = number of times interest applied per time period
  • t = number of time periods elapsed

important to understand

The money you contribute must stay in your account.

Think of it as money you won’t see again for the next 15, 20, or 30 years.

If you start taking money out, you’ll lose thousands and thousands of dollars. You have to let compound interest do its magic. The exponential growth will take some time but when you reach it, it goes up really fast.

Compound Interest Examples

example #1

Waiting 30 years vs 20 years.

The longer you wait the better, much better.

Here’s an example of waiting 30 years vs 20 years.

In both scenarios, you start with and only invest $50,000. The difference? Time. After 30 years, your total return is $503,132.84. After 20 years, your total return is $233,047.86.

A ten-year difference equals $270,085.

I don’t want this example to discourage you from investing and think “you’re to late too start”. It’s never too late to start investing. Would you rather have nothing or more? Even if it’s a little more?

I had the fear that I had missed out on compound interest because I didn’t start investing in my early 20s. I started investing in the stock market when I was 30. If I wait 30 years, I’ll be 60, right in line with retirement so I know I’ll be just fine.

example #2

Contributing $250 vs $500.

The more you contribute, the better. Although making no contributions will also make you money, see example #1 above.

So what’s the difference between a $300/month vs a $500/month contribution?

The difference is $339,849.63.

Guys, that’s a lot of money. I’m sure you can find a way to contribute $500 instead of $250.

The more you invest the better!

example #3

Making only one initial investment and only having to wait.

Let’s say you invest $100,000 and make no contributions over 30 years. How much will you have at the end of 30 years?

You’ll have $1,006,265.69.

For doing nothing but waiting, that sounds really good to me!

How To Earn Compound Interest

After understanding what compound interest is and seeing for yourself how much it can impact your investment. I’m sure immediately going to ask, How can I earn compound interest?

You’ll need to open an investment account. You can either meet with a Registered Investment Advisor (RIA) or open an account yourself.

One way to mimic the return of the S&P 500 and get the same return is to invest in an index fund that mirrors the S&P 500. You have a lot of options, just do your research. If you want to learn about index funds, read,.

If you’re not comfortable with investing on your own. I highly recommend meeting with an RIA.

final thoughts

My goal in writing this is to help you understand how powerful compound interest is.

You don’t have to do anything except make monthly contributions. You saw the difference a $250/month contribution can make. It can cost you $340,000! For reference, see example #2 above.

Let time work in your favor and start ASAP. The longer you wait, the better!

In summary, think of compound interest as a snowball going down Mount Everest. The snowball at the top starts small but as it goes down it gets bigger and bigger. The longer the slope, the bigger the snowball.

In addition to saving $2,050 every month.

I also:

How did I increase my savings by 105% in 1 hour? The Bulk Budgeting Technique (BBT). And in this case study, I’m going to show you exactly how I did it, step-by-step.

The Bulk Budgeting Technique: How I Increased My Savings by 105%

After executing The Bulk Budgeting Technique, I increased my 401(k) contribution to 20%!

Most importantly, I reduced my shopping trips by 50% because I bulk shop and buy enough to last me three months.

And my favorite…I tripled my No Spend Days!

All the zeros you see on my sheet are my no spend days. In March 2022, I had 23 no spend days!

The best part?

You can do the same thing for your budget. You don’t have to earn six figures a year or deprive yourself of your favorite things to significantly increase your savings.

The 3-Steps to Using “The Bulk Budgeting Technique” To Dramatically Increase Your Savings

There are 3 steps to The Bulk Budgeting Technique.

Step 1: Understand Savings Potential

Step 2: Consolidate Budgeting Months & Shopping Trips

Step 3: Track Your Progress Daily

Here’s why this technique works so well.

You prioritize saving right from the beginning.

You don’t save what remains. You spend what remains after saving.

You focus on bulk spending which means you buy enough to last you a few months rather than a few days or weeks.

The Bulk Budgeting technique is not limiting; it’s freeing.

Step #1: Understand Savings Potential

The first step in The Bulk Budgeting Technique is to understand your saving potential.

What does that mean?

It means you take the time to understand how much you can save each month.

It’s great to say you want to save $1,000 each month but what if you can’t?

The foundation of any successful budget is setting realistic expectations.

That being said, most people underestimate how much they can save.

It’s not until they crunch some numbers that they see the true potential.

To understand your saving potential, follow the seven money management steps.

Here’s a short video that explains each step.

1. CONFIRM MONTHLY INCOME The first step is to confirm how much you make each month.

If your income varies from month to month, your task is to understand the minimum amount you earn each month.

If you get paid a few times a month, list each paycheck amount and sum the total.

2. SET ASIDE MONEY FOR FIXED EXPENSES The second step is understanding how much you have to spend on bills each month.

Fixed expenses are the bills you have to pay each month.

They include your rent or mortgage, utilities, car insurance, gas or public transportation, cell phone, etc.

Make a list of your fixed expenses, and sum the total.

3. SET ASIDE MONEY FOR DEBT The third step is understanding how much you have to spend on consumer debt each month.

Consumer debt includes student, car, and credit card debt.

This is the perfect opportunity to zero in on your debt and understand your total payment.

Make a list of your debt expenses, and sum the total.

4. CONFIRM FIXED PLUS DEBT EXPENSES TOTAL The fourth step is simply adding your fixed and debt expenses.

I call these mandatory expenses because they are the bills you have to pay each month.

At this point, you understand the total dollar amount that you have to spend each month.

Your mandatory expenses total is a very important number to understand. Whether good or bad. If you are spending more than you want, at least you are aware of that now!

5. SET ASIDE MONEY FOR SAVINGS The fifth step is where you get the opportunity to prioritize your savings!

Remember, it is not about saving what remains after spending.

It’s about spending what remains after saving.

First, confirm your remaining income (=Income – Mandatory Expenses) after setting aside money for mandatory expenses.

Next, choose the amount you want to save.

Lastly, the remainder (=Income – Mandatory Expenses – Savings) is what you will spend on variable expenses.

How do you know what remains is enough for your variable expenses?

You won’t know exactly but you can do your best to make it work.

What remains is spent on categories that are under your control.

You get to choose how much you spend on groceries, eating out, clothes, streaming and subscription services, accessories, etc.

If you’re at a point in your life where not a lot remains after setting aside money for mandatory expenses, please know that understanding that is the first step to choosing to change it.

Understanding my savings potential is what helped me increase my savings by 105% in 1 hour.

Before, I was saving $1,000 a month. Now, I save $2,050 every month.

It’s that simple step of understanding your savings potential and then choosing how much you want to save before you spend on anything else that’s life-changing.

Most people don’t see saving that way but they should.

6. CONFIRM VARIABLE EXPENSES BUDGET The sixth step is confirming your variable expenses budget (=Income – Mandatory Expenses – Savings).

The total is your monthly budget moving forward!

Your monthly budget will be spent on: The list above does not represent categories.

It’s a list of expenses that are paid with your variable budget.

7. CHOOSE CATEGORIES AND ASSIGN A BUDGET

The seventh and final step is to choose your variable categories and assign each a budget.

Do your best to simplify your categories.

There’s no right or wrong number of categories but there’s a high probability you don’t need 10.

Start with the essentials such as groceries, household, personal, and fun.

Yes, everyone should have a fun category!

Make a list of your variable categories, and sum the total. The total should equal your monthly budget.

I encourage you to save for future expenses in the form of sinking funds.

If you do, a sinking fund becomes one of your categories.

A sinking fund (or savings fund) is a future expense that you save for each month. You typically put aside a little each month until you’ve achieved your goal.

Common sinking funds include Christmas, Vacation, Back to School, etc.

After successfully prioritizing your savings and understanding your monthly budget moving forward, it’s time to learn how to stick to both goals. Here is a recap of all seven money management steps using my real numbers:

The Bulk Budgeting Technique Summary

I hope you feel motivated and look forward to implementing The Bulk Budgeting Technique in your money management routine!

I hope you feel motiYou only have to follow three steps to start implementing this technique: vated and look forward to implementing The Bulk Budgeting Technique in your money management routine!

Step 1: Understand Savings Potential

Step 2: Consolidate Budgeting Months & Shopping Trips

Step 3: Track Your Progress Daily

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