Compound interest is hands down the most important concept to understand in the world of personal finance.-THE MILK MAN
Yes this is a bold claim (LOL get it?), but once you understand compound interest, it will forever change the way you view a dollar. So rather than diving right into the numbers, let start with the soon to be famous story of Chunk and Slim…
Once upon a time, in a not so distant land, there existed two fellas named Chunk and Slim. They lived on top of an enormous snow-covered mountain and had been best friends since birth. However, they could never seem to agree on anything…
One day, a wealthy princess visited their mountain and informed them that she would pay $1M dollars to whichever one of them could deliver the most snow when she returned in 40 days.
Wide-eyed and excited, Chunk and Slim immediately climbed to the top of the mountain peak to begin collecting snow. They both had the same idea: start with a small snowball and roll it down the mountainside. As the snowball rolled it would pick up snow and become larger.
So Chunk and Slim rolled their snowballs down the mountainside and returned the next day to recover them. They both saw that their snowballs had rolled exactly 365 feet before stopping.
Slim always focused on the present and thought short-term, so when he saw his snowball had grown a bit, he immediately shaved off the accumulated snow and placed it in his bag. He then took the original sized snowball and rolled it down the mountainside again.
Chunk was more of long-term thinker. He decided not to spend time shaving off the extra snow from his snowball. Instead he just rolled his slightly larger snowball down the mountainside and left with an empty bag.
This daily routine continued for 39 more days. Everyday the snowballs rolled exactly 365 feet. Everyday Slim shaved the extra snow into his bag, while Chunk just kept rolling his snowball and leaving with an empty bag.
After 40 days Slim was as confident as could be. He had collected snow daily for 40 days while Chunk was being “lazy” and hadn’t collected a single flake yet.
When the princess returned Slim had enough snow to fill an entire freezer and Chunk was nowhere to be found. As the princess was writing the $1M check for Slim, they suddenly saw a large truck approaching…
Chunk was driving a dump truck full of snow! Slim couldn’t believe his eyes! “How is this possible?! Where did you get all this snow from?”
Chunk stepped out of the truck smiling ear-to-ear and said two words:
He went on to explain that as his snowball grew in size, the surface area also increased. So, every time he rolled his snowball, it picked up more snow than the previous day.
The princess, enamored by Chunk’s wisdom, immediately tore up Slim’s check, wrote a new one for Chunk, and then asked Chunk to join her for dinner.
Chunk…What. A. Legend. This soon to be famous fairy tale demonstrates the power that compounding interest can have when combined with time.
Now that you have an idea how compounding interest works, let’s make things a bit more concrete by putting some numbers behind it:
Imagine you invest $100 at the beginning of the year and earn a 5% investment return. You roll a snowball with 100 flakes down a hill and the snowball picks up an additional 5 flakes before it stops rolling.
After one year you will have $105. Now instead of celebrating and spending the $5 you just made on a beer, imagine you keep that money in your investment account and earn another 5% investment return the next year. Don’t shave off the extra 5 flakes into a bag like Slim. Instead roll the slightly larger 105 flake snowball down the mountain again like Chunk.
After the second year your account has grown to $110.25, not $110, meaning you made $5.25 this year instead of $5! This is due to the fact that your snowball in the second year ($105) was slightly larger than the snowball ($100) that was used in year one.
“An extra 25 cents?! Wow thanks compounding interest! Now I’m rich!”
This is precisely where time comes into play. Time is your best friend. Let’s have a look at the same example of investing $100, except this time lets extend it to a 40-year time horizon:
Now lets check how that measly $100 is doing…
After 10 years you have 1.6x more money,
After 20 years 2.65x,
After 30 years 4.32x,
After 40 years that measly $100 you put away would have grown over 7x!
That my friend is the power of compounding interest. Instead of growing at a flat amount each year, your $100 snowball grows faster and faster, as after each year it has more snow and more momentum.