How to make your money grow
About this video
Comparing $1,000 at 16% per year, simple interest adds the same $160 every year, while compound interest pays interest on the interest already earned, so year two adds $186 instead of $160. The gap grows over time until, after 20 years, compounding gives more than four times the money. Savings accounts, CDs and stock market returns compound if you leave the earnings in, so starting early matters.
You'll be able to
- calculate simple interest over several years.
- explain why compound interest grows faster than simple interest.
- explain why starting to save early makes a big difference.
Key words
- Simple interest
- Interest paid only on the original amount, so you get the same amount every year.
- Compound interest
- Interest paid on the original amount plus the interest already earned, so it grows faster each year.
- Interest rate
- The percentage of your money paid to you as interest each period, like 16% per year.
- Principal
- The original amount of money you put in, such as the $1,000 in the example.
Transcript
- [Instructor] In this video, we're going to talk about the power of compound interest. And to help us understand that, we're gonna compare it to simple interest. Simple interest, let's say we have a interest rate of 16% per year and we put in initially $1,000.
Simple interest would tell us that every year that goes by, we are going to get 16% of that $1,000 added to the amount of money we have. So 16% of 1,000 is $160, and you can see right over here every year that goes by, we are adding $160. Now, compound interest at first it might seem like a small or a subtle change, but it has huge consequences.
And over here, we've calculated compound interest for several different interest rates. But since we had 16% on the simple interest, let's compare that to 16% on the compound interest. So in the first year it looks very similar. We start with $1,000, 16% of $1,000 is $160 so we added $160, but we start to see a difference in year two.
What do you think is the difference why we are now adding, if we just added another 160, we would get to 1320 like we had here? But here it looks like we're getting 26 extra dollars than we had before, where did that $26 come from? Well, it's because we're not just getting 16% on our original $1,000 like we had in our simple interest, we're getting 16% on the amount of money we had in the previous year, and the previous year had interest from the year before that included in it.
So we're actually getting interest on the interest. So we're getting 16% on the $1,000 and then we're also getting 16% on that $160 that we got the previous year. You add 'em together and we're getting more money. Now you might say, "Hey..." Now lemme just write that down.
This looks like we got a $186 in year two. Now this might seem like a small change, but when you really compound its effect, no pun intended, or actually pun is very much intended, you see that it really builds. And time is a really important factor. Compounding interest really pays off over time.
Look at the difference after 10 years, it looks like we have almost 50% more money with the same interest rate. It's just compounding in this situation versus it's simple in the other one. But after 20 years, we have almost... Or actually we have more than four times the money.
So compound interest is a very big deal. The good news is most accounts that you have that are giving you interest, as long as you keep the interest that you're earning in the account, they compound. So whether it's your savings account, a certificate of deposit, or even if you're thinking about returns in the stock market every year, the return you're getting if you're keeping all your money in the account, it compounds on the previous year.
And what you could see is that time really, really, really matters. Sometimes you might think at the beginning of your career, "Oh, I can only save $50 a month, "$100 a month, $200 a month," but if you start early and you get reasonable interest rates and you allow that to compound over time, it can turn into a lot of money.
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