Why Albert Einstein loved compound interest

Why Albert Einstein loved compound interest

History’s most famous scientist is said to have once described compound interest as “the eighth wonder of the world”.

“He who understands it, earns it; he who doesn’t, pays it,” Albert Einstein reportedly said.

The beauty of compound interest is that it allows you to earn interest on your interest – so that while you have to sweat to earn the money you initially invest, from then on your money works on your behalf.

There are three rules to get the most out of compound interest:

  1. Reinvest the dividends
  2. Invest over the long term
  3. Keep adding money

The benefits of reinvesting the dividends

Imagine you invested $1,000 in a fund that provided a return of seven per cent per annum (compounded monthly).

If you were the sort of person who wanted to get their hands on the profits as soon as possible, you’d be able to pocket $70 of interest every year. However, if you reinvested the profits, you’d eventually be able to collect even more money, as this table shows:

Year Interest Investment
0 N/A $1,000
1 $70 $1,070
2 $75 $1,145
3 $80 $1,225
4 $86 $1,311
5 $92 $1,403

So by the fifth year, your annual interest would have risen from $70 to $92 – an increase of 31 per cent.

To put it another way, over five years, you could earn $403 by reinvesting your interest compared to $350 if you pocketed the dividends each year.

The benefits of investing over the long term

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The longer you leave your money untouched, the more powerful the compounding effect becomes.

Take the previous example – after five years, you’d not only be earning interest on your original $1,000 investment, you’d also be earning interest on your $403 of interest.

After 10 years, your original $1,000 would become $2,010. That means your annual interest would be $1,010 – more than your original investment.

After 20 years, you’d have $4,039. After 30 years, you’d have $8,116. So you’d earn more money in the last 10 years than in the first 20.

The benefits of adding money

Imagine that as well as leaving your money untouched for 30 years, you also added, say, $10 per week.

That would make the compounding effect even more powerful, as this table shows:

Time Original deposit Extra deposits Interest Total
5 years $1,000 $2,600 $920 $4,520
10 years $1,000 $5,200 $3,310 $9,510
15 years $1,000 $7,800 $7,784 $16,584
20 years $1,000 $10,400 $15,212 $26,612
25 years $1,000 $13,000 $26,829 $40,829
30 years $1,000 $15,600 $44,382 $60,982

Thanks to the power of compounding, you’d earn $34,370 in the third decade compared to $26,612 in the first two decades – that’s 29 per cent more money in half the time.

Of course, if you added more than $10 per week, your financial position would become even stronger.

Here’s what would happen if you added up to $100 per week for 30 years:

Scenario Original deposit Extra deposits Interest Total
$10 per week $1,000 $15,600 $44,382 $60,982
$25 per week $1,000 $39,000 $100,280 $140,280
$50 per week $1,000 $78,000 $193,444 $272,444
$75 per week $1,000 $117,000 $286,607 $404,607
$100 per week $1,000 $156,000 $379,771 $536,771

As the numbers show, if you have the discipline to make regular deposits and the patience not to touch your money, you can turn a little into a lot.

Compound interest might not be as remarkable as Einstein’s theory of relativity, but it’s close.

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