One of the fundamental concepts in a personal finance course is the power of compound interest. Einstein labeled it the 8th wonder of the world. Interest on the surface is a simple concept. I borrow money, I pay the lender the money back and some interest. If I loan someone money, they pay me the amount I loaned them plus interest. Interest is the cost or price of money in economic terms. When examining the details, interest can be difficult to understand. These details include how it is calculated, whether the principal is paid in one or multiple payments, and the effects it can have on both the borrower and the lender over time.
The most basic type of interest is called simple interest. You borrow $100 and agree to pay 5% interest. Each year, you will pay 5% of the outstanding balance until the loan is paid in full. Another type of interest is called compound interest. The best way to think of this loan is to put yourself in the shoes of a saver. You deposit money in a savings account. By doing so, you are loaning the bank money at a very low interest rate so they can then loan it to borrowers at a higher rate. At the agreed time, usually once every 3 months, the bank will pay you interest at the agreed rate. You can choose to spend the interest or leave it in the account. If you leave it in the account, the bank will have to pay you interest 3 months later on the amount you put into your account initially plus the interest you left in there. Now your money and the money the bank paid you are earning interest for you. If the rate stays the same, each subsequent interest payment you receive will increase. Over time, the rate of growth can become extremely large. Think of compound interest as building a snowman. You start with a small snowball and roll it around in the snow to pick up more snow. As the surface area of the snowball increases, it has the ability to attract more snow allowing you to form the base of the snowman.
How big an impact compound interest will have is based on the interest rate paid and the amount of time the money is left to compound. The second point is what I want to emphasize in this post. Everyone needs to understand how starting to save and invest early is important to becoming financially fit. Starting early allows the power of compound interest to get to the point where the savings or investment grows at a very large rate.
A few years ago while working on my doctorate degree, I had to create a video that presented a problem in multiple ways. I convinced my group to do a video on the importance of starting early when investing. Rather than presenting the problem as investing, we decided to demonstrate the power of starting early in a different way. Rather than tell you about it, I want you to watch it yourself and see if you come up with the correct answer. If not, can you figure out why the correct answer is what it is? Once you understand the answer, you will understand how to turn something small into something big.