- [Narrator] Would you rather work hard for money
or have money work hard for you?
Compound interest empowers you with that choice.
Compound interest is a core financial principle
that can drastically increase your wealth over time.
But before we explore compound interest,
it's helpful to understand simple interest.
Simple interest is the interest you earn
on just your principal.
Let's say you invest $1,000
and earn 5% simple interest for five years.
In year one, you'll earn $50
which is 5% of your $1,000 principal.
In year two, you'll earn another $50
and each year thereafter you'll continue earning $50.
As you can see, simple interest remains constant over time.
Compound interest is a different story.
Let's say you invest your $1,000 in a savings account
that compounds annually with interest of 5%.
In year one, your interest is still $50.
However, assuming you keep your interest earnings
in your account,
your dollar interest will increase every year.
In year two, you'll earn $52.50.
In year three, you'll earn $55.13.
Why? Because you're adding your interest
to your principal each year
so you're earning 5%
on a perpetually increasing amount of money.
Compared to our first example,
you earned an additional $26.28 of interest or 10.5% more
over the same timeframe.
This growth is known as compound interest
which enables you to build wealth without lifting a finger.
As the name implies, compound interest
is the idea of interest on interest
which occurs when you reinvest interest earnings
to make more money.
So long as you continue to reinvest your interest,
your passive income will exponentially grow.
Beyond calculating the growth of funds in a savings account,
you can also compound interest
to estimate the long-term growth in a stock portfolio.
Let's compare the difference between saving money
and investing money using compound interest.
If you set aside $365 per year,
the equivalent of $1 per day and put it in a safe,
you'd have $365 after one year,
$730 after two years, $995 after three years and so on.
If you continue this cycle for 40 years,
you'll eventually save $14,600.
While saving is important, true wealth cannot be achieved
without the benefit of compound interest.
So what if you regularly invested your $365
in something with a higher rate of return
such as the stock market?
The historical average annual return of the S&P 500
is about 10%.
Dating back to the 19th century,
if you annually invested $365 into an index fund
that tracks the S&P 500,
your investment could be worth $396 after one year,
$832 after two years, $1,311 after three years and so on.
After 40 years, your shares of the index
could be potentially be worth $177,701.
That's a significant increase
compared to letting your money sit idly in a safe.
As you increase your annual investments,
the future value of your portfolio exponentially increases.
Although it requires a long-term outlook,
compound interest can amplify your wealth trajectory,
help you prepare for future financial needs
and improve your general lifestyle.