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- While I’ve definitely made some money mistakes in my life (who hasn’t?), I’m lucky that my parents provided me with a solid base of financial knowledge.
- They taught me many money lessons that have come in handy over the years, but there’s one thing they did an especially great job of driving home – the power of compound interest.
- I learned how big an impact compound interest could have on my net worth after making my first major purchase in high school – a Coach purse.
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Growing up during a period when the market was relatively volatile (the 1990s), it was important to learn good financial habits from a very young age. Fortunately, my parents were there to help steer me in the right direction, and they gave me a few words of wisdom that I will never forget.
But before I tell you about that, allow me to offer a brief review of basic algebra. Remember the days of poring over your homework assignments on simple and compound interest? Did you think you’d never need to use this in the real world? Think again.
Understanding the math behind compound interest
To understand compound interest, we need to understand how it’s calculated. The compound interest formula takes into account more information than simply the principal amount you invest, the rate of return, and the time period of investment. That’s the simple interest formula.
Compound interest diverges from simple interest in the sense that it allows additional mathematical wiggle room for multiple compounding periods and exponential growth.
For example, let’s say you’d like to invest $10,000 at an annual interest rate of 3%, compounded monthly for 20 years. How much money will you have made at the end of those two decades?
Well, let’s start with your principal $10,000. That’s what you have to begin with, and to find out what you’ll end up with, we need to account for the combined effect of your interest rate divided by the number of times the interest is compounded per year (12, for compounding monthly) and then exponentially raise that to the total number of times your interest is compounded.
That value would be 12 times each year for 20 years, or 240 total times. At the end of those 20 years, your $10,000 investment will have grown to roughly $18,207.55 at a 3% interest rate, having given you a return of over $8,207. Who couldn’t use that?
So, what does this have to do with my parents? Their best financial advice to me was to invest early, then reap the benefits of compound interest. Choosing long-term gains over short-term spikes in my financial portfolio has been my go-to move ever since, and over time, exponential growth certainly starts to pay off.
How a Coach purse taught me my biggest financial lesson
They really drove this point home. I remember one time I came home from the mall after making my first big purchase that I had saved up for: a Coach purse. I don’t remember how much this bag cost, but for argument’s sake let’s say it was $200. My dad said something along the lines of, “I hope you’ll enjoy that $1,500 purse!” to which 16-year-old me responded, “Dadddddd, it didn’t cost that much, it was only $200!”
The point my dad was trying to make was that if I had invested that money instead of buying a purse, it would be worth more, a lot more, in five, 10, 30 years than it was today. It was a lesson that made sense to me once he showed me some math.
Playing the long game
Of course, the three main things that contribute to a hefty interest payout are your principal amount, the interest rate, and the number of times the interest is compounded.
Of those, I’d say that the rate itself is less important than the total number of times compounded, because that number of times compounded is what sets the exponent in the mathematical relationship.
The more times my interest compounds, the higher return I can enjoy later. And also balance that with using my money to enjoy things I love now.
A high-yield savings account is a great place to store your money and watch compound interest help it grow:
For me, it’s a lesson in patience and know-how. I could invest my lump-sum and pull it out after a couple of years, but what’s the point of that? Investments don’t grow much overnight; that’s mathematically how exponential functions work. They need time to grow. Worse yet, I could stick my cash in a low-interest savings account and never see anything accumulate.
With a basic understanding of the mathematics of compound interest as well as a familiarity with our banking system, I was fortunate to learn how to take advantage of high-yield accounts and favorable interest at a very young age.
By investing early and understanding the ways I can effectively earn interest, I’ve been able to watch my investments grow. If you haven’t had the chance to do so because you weren’t sure how, now you know! You can thank my parents for that.