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Compound Interest

Compound interest is a fairly simple concept. It is the idea that income on an investment increases at a rapid rate when interest is paid into the account at frequent intervals. What it really means is that the interest paid on an account is now also earning interest.

To illustrate how this works imagine $1000.00 in an account that earns 6 percent. If the interest is paid yearly (called simple interest) the money will earn $60.00 at the end of the year. However, if this amount were to compound monthly, the first month would pay $5.00, but this amount would be added to the $1000.00 and the next month's interest would be on $1005.00 instead of the $1000.00. So the interest for the second month would be $5.02 and a half cents.

Month Account Value
Begin with $1000.00
X 6%/12 months
0 $1000.00 $5.00
1 $1005.00 $5.025
2 $1010.025 $5.05
3 $1015.07 $5.075
4 $1020.145 $5.10
5 $1025.25 $5.12
6 $1030.38 $5.15
7 $1035.53 $5.17
8 $1040.70 $5.20
9 $1045.90 $5.23
10 $1051.13 $5.26
11 $1056.39 $5.28
12 $1061.67 -
Not much of an improvement on first blush, but the next month would garner the account a little more extra cash. In the third month then, the interest would be on 1010.02, which would equal $5.05. The table at left illustrates how the first year of compound interest would go. It would earn an extra $1.67. An effective interest rate (if the same account were earning simple interest) of 6.167%. This is not much in the short term, but over time, the compound interest would generate an increasing amount of revenue by continuing to garner interest on the interest.

At 6% interest, an account will double in about 11.6 years with interest compounded monthly. Even the account that pays interest only on an annual basis would be experiencing compound interest. It would take about 12 years to double. If an account were to simply pay out 6% annually without the action of compounding for the total amount, interest plus dividend to double would take 16.7 years. Now, you can see that after 46 years (doubling two more times), the account with monthly compounded interest would be worth $8000.00. While a person simply drawing 6% annually off the account would only receive $2880.00 (1000 X .06 X 46) plus he would still have his $1000.00 in principal.

This idea of compound interest then speaks volumes about placing money in secure investments that compound in a frequent time frame.

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There is an excellent illustration of how this works in Douglas R. Andrew's book The Last Chance Millionaire: It's Not Too Late to Become Wealthy.

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