“The most powerful force in the universe is compound interest.”
“Compound Interest is the 8th wonder of the world. He who understands it, earns it. He who doesn’t… pays it.”
Albert Einstein is generally credited with these words of wisdom that have rightfully earned their worth as the investor’s mantra. When you are investing in notes you are harnessing the power of compounding interest. So what’s the big deal with compounding interest (and what in the world does it have to do with cake)?
Let’s start with a look at simple interest…
Simple Interest Is Interest On Principal
Let’s say you had $10,000 and invested it at 10% per annum (or per year). At the end of the first year you would have $10,000 x .10 which equals $1,000 of interest earned for the year. Pretty straight forward but what happens in 10 years?
You will still have the principal of $10,000
Plus 10 years of interest ($1,000 x 10 = $10,000)
So you could double your money in ten years when earning 10% all from the power of interest. Not bad but it gets better…
Compound Interest Is Earned On Principal AND Interest
So if you invested $10,000 at 10% per annum that first year you would still earn the same $10,000 x .10 resulting in $1,000 of interest. But what happens the next year is where the magic happens.
The Interest earned is added to the Principal each year.
At the end of the first year the $1,000 of interest is now added to the $10,000 principal for a total of $11,000 and interest is now earned on that higher amount.
The second year the calculation is $11,000 x .10 equaling $1,100 earned. And every year thereafter that higher amount of interest is added back to the principal compounding the effect.
So what happens in 10 years?
Compound – Interest on Principal AND Interest
$25,937.43 after 10 years
Simple – Interest on Principal
$20,000 after 10 years
A difference of $5,937.43!
It was the same $10,000 Investment at the same 10% Interest Rate. The only change was how the interest earned was handled at the end of the year.
Was it accrued separately (simple interest) or added back to the principal (compound interest)?
That one simple difference is the power of compounding interest!
But wait! There’s still more…
Interest Compounding Periods
If you can shorten the time between the interest being added back to the principal (aka the compounding period) you have even better results. Instead of waiting a whole year to add back the interest what would happen if you did it every 3 months or even monthly?
Using a quarterly compounding period the same $10,000 would grow to $26,850.64.
Using a monthly compounding period the same $10,000 would grow to $27,070.41.
So where can an average person find an investment vehicle that has the potential to earn 10% using a monthly compounding period? Of course that’s a rhetorical question because you are already reading this article on note investing!
Monthly Compounding Is The Note Investing Standard
Financial calculators let you set the compounding period and most note investors use a monthly compounding period to determine a purchase price at their desired return or yield. The examples show what a big difference this can make which is why we spend time in the Calculating Cash Flows tutorials going through how to adjust these settings on the financial calculator
The banks and wealthy have been capitalizing on compounding interest for centuries. Sadly, the average American is a slave to paying interest (on their cars, credit cards, student loans, and homes). Making the shift to earning interest instead of paying it is a monumental step in living debt free and securing financial freedom.
Anything is possible with the power of compounding interest behind you!
You don’t need the IQ of Einstein, a financial degree, or even a love of math to master the concept. Join me in the How To Calculate Cash Flows training for step-by-step tutorials. Whether it’s one small note or a whole portfolio, I invite you to experience the power of compounding interest in your own life.