Simple Interest

I'm going to take you back to math class for just a brief moment... but stay with me here! If you get this, you will understand the foundation of what could lead to life-changing wealth for you!

Consider that you loan $100 to someone for one year. You are basically giving up your use of the money for an entire year, so you're not going to do that for free!

In consideration of your sacrifice, you charge 7% interest, yielding $7 at year's end. With the return of the $100 principle, you'll have a total of $107 in your pocket.

Pretty cool deal- $7 for no direct labor on your part. You get paid to let other people use your money for a period of time. Its like a rental on your $100.

Ok, you got through a whole year, not really missing your $100, so you decide to replay the deal for another year. You loan your $100 for another year, leaving you with a $7 earnings windfall from the first year's loan to spend as you see fit.

Here's what happens if you replay this scenario over 10 years:

At the end of the decade, you will have earned $70 simply for letting others use your $100. And you still have your $100!! You've supplemented your earned income with $70, and you didn't need to get a second job to do it!

Ok, maybe $70 over 10 years is not all that much to get excited about. I hear ya... so let's take it to the next level...

Compound Interest

What would happen if you had not spent the $7 earnings throughout the years? I mean, if the plan works well when loaning $100, it should be even better when loaning $107, right?

Let's see how this plays out...

The first year looks the same as before. You loan $100 and get $107 back at year-end. The difference starts in year two; you loan $107 and get $114.49 back at year-end.

Compare this to the simple interest scenario. With simple interest, you would have earned a total of $14.00 by the end of the second year. By compounding the earnings, you have earned $14.49.

Now follow the pattern- don't spend the interest. Let it rollover into the next loan period. A loan of $114.49 will yield $122.50 at the end of year three. Compared to simple interest which would have paid you $21 at this point, by rolling the earnings back into the investment, you've gained an extra $1.50.

Ok, now let's see what our new and improved decade looks like:

Congratulations! By letting it ride, you've made an extra $26.72 this decade! You've nearly doubled your money this time around. How 'bout them apples?

Hello? Still there? This wasn't the result you expected for producing life-changing wealth, you say? (I'm sorry, I had trouble hearing over those blasted crickets chirping in the background.)

Ok, I can see you are a tough customer... and rightfully so. Giving up not only the use of your original $100 but also the annual interest payments for 10 years to make a whopping $96.72 is not going to change your life... or is it?

Compounding over the Long Haul

Take another look at the compounded earnings shown above. Did you notice that every year you earn more on your Nest Egg? It grows faster and faster.

Let's extend the calculations over a few decades:

Over 50 years you have earned $2,846 off of your initial investment of $100. With a total of $2,946 you have grown your money by more than 29 times!!

(Compare that to the $7 * 50 years = $350 earned by simple interest.)

Extra credit: Did you notice that the nest egg nearly doubles every 10 years? See the Rule of 72 to see why.

The chart below illustrates the difference between compound and simple interest over a lifetime.

Compounding over time is the power that can lead to life changing wealth!

Compounding eventually leads to a situation where your money will yield more income than your full-time job — if — you start early, and are disciplined to not spend the principle or the earnings until you are ready to retire!

Next, visit this page to see an interactive chart where you can see a comparison of different rates compounded over time.