Do you understand it well enough to explain it to a 5 year old? If not, stop what you are doing and read this. Understanding this concept, while basic, can mean the difference between retirement and working until your last days.

What Does Compound Interest Mean?

Compound interest itself is no secret, yet clearly, even super rich people don’t understand what it means. Let’s take a closer look at what he explains in the video.

To begin, “compound” means to augment or intensify.

Compound interest refers to the way money grows larger (or augments) with interest. In the banking world, there’s a difference between simple interest and compound interest, but let’s just look at what you actually need to know.

At the most basic level, you should know that the more money you save and invest, the more you will gain in investment returns and interest. As your money grows, it will compound more quickly. The new growth will be based on a higher balance, which will mean you will passively gain more dollars every year.

An Example Of Compound Interest To Make It Clear

Let’s compare two people. ‘Sam the Spender’ and ‘Sue the Saver’. Both earn the same amount of money and live in the same neighborhood. However, ‘Sam the Spender’ only has $6,000 in the bank. ‘Sue the Saver’ has $11,000 in the bank. She’s crushing it.

To keep it simple let’s assume that’s all they will be able to save for the next 10 years.

But they are able to invest their money in stocks at an annual return of 5%. What would happen if they forget about the money and don’t touch if for 10 years? See below.

Wait a second, if they both earn 5% on their money, why does Sue end up with $7,757 MORE than Sam? I thought she started with only $5,000 more?

That my friends, is the power of compound interest.

Maybe, it’s time to learn how to make a budget.