All of finance is compound interest.
This is, of course, an exaggeration. But only slightly. So much of what you need to know involves how money compounds. If it’s your money, compounding is very good. If it’s money you owe to someone else, it’s very bad.
The concept of compound interest here is simple: If you earn interest on your money, that interest you earn can earn interest in the future.
I’ll give you one basic example, but then you have to play with the numbers on your own to truly understand what’s happening here. Suppose you have $100 in a bank account. You never do anything with this money– it just sits there. The bank pays you interest on this money.
Interest rates are very low right now, and some banks pay almost nothing. Even the highest interest savings accounts only pay 1.70% per year these days. But let’s pretend we’re back in the year 1995 when you could earn 6% on your money.
After a year, your $100 is now $106– the original $100 plus 6% of $100, or an extra $6.
By the way, the bank pays you this money as an incentive for you to lend them your money. They take that money and lend it out to businesses or people buying houses, and at a rate higher than 6%. As long as everyone doesn’t ask for their money back at the same time, the system usually works!
Now you have $106 to start year 2. You get 6% interest on $106 now, or $6.36 in interest. Last year you got an extra $6, and this year you got an extra $6.36. The following years you’ll get $6.74, and then $7.15, and then $7.57, and so on. That’s compound interest.
It doesn’t seem so exciting here. But if you’re young, and leave the money there for say 50 years, your original $100 is now worth $1,842. And in that 50th year, you earn $104 in interest. The interest payment that year is more than your original deposit!
Okay, your turn. Open up a new spreadsheet. If you have Microsoft Excel, use that. Or you can use Google Sheets, which is free; you only need to sign up for a Google account. I’ll show examples for both.
You can also use a free version of Excel online. It’s not as fancy as Office 365 or the desktop versions of Excel, but it will work just fine for this class.
Here’s how to do our 6% example in Excel:
(You may or may not get any decimal places … we’ll fix that later.)
Notice that after I type the equal sign in the second cell, I click on cell A1, and Excel fills in “A1”. I also could have just typed “A1”.
Also, I multiply each cell by 106%. I want to take all of what I had before (100%) and add an extra 6% in interest. That’s a total of 106%. I also could have typed 1.06: =A1*1.06
Finally, I drag the formula down. Notice that the pointer changes to a black plus. You only get this if you’re right at the corner of a cell:
It’s the same process in Google Sheets:
I did both of these for 25 years … well, 24 years of compounding. Notice in that last year we go from $382 to $405– $23 in earned interest on your original $100 deposit!
Please make sure you can do the above spreadsheet work before continuing on. We’re going to build on this and make more complex spreadsheets. We’ll look at how changing the interest rate even a little bit can have a big impact on the final value.
If you’re having trouble, e-mail me!
We’ll also look at some examples of common compounding examples. Like how investing $100 a month can turn into over $500,000 in 50 years. Or how skipping a $3 coffee every day can turn into $1 million after 40 years. And how those statements together can’t both be true! (Think about it: $3 a day is less than $100 a month, and 40 years is less than 50 years.)
And of course, we’ll look at actual investment returns, where making a steady 6% per year isn’t how it really works.