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The Magic Of Compound Interest

The Magic Of Compound Interest

Christians are called to be good stewards of God's resources. A steward can be described as someone who manages the resources of another. "The earth is the Lord's and all that is in it, the world and those who dwell therein"-Psalms 24:1 (The New English Bible). To effectively manage God's financial resources, it helps to have some understanding of modern day financial concepts, strategies, and mathematical formulas. Compound interest is a great ally in catapulting you toward achieving your financial goals. Through an understanding of compound interest, God can pour out a blessing upon you, which you will not be able to measure! Albert Einstein once called compound interest "the world's most impressive invention" and dubbed it the "eighth wonder of the world." Compound interest means all the money you've invested earns interest and then the combined amount of the original investments plus your interest earns more interest. Compounding means interest added to interest. Compound interest does not produce linear growth like the pattern 1, 2, 3, 4, 5, 6, and so on; it produces geometric growth through compounding like the pattern 1, 2, 4, 8, 16, 32, and so on. Usually, the more frequently your money compounds when earning interest, the better. For example, daily compounding is normally better than monthly compounding, which is better than quarterly compounding, which is better than yearly compounding.

A basic formula for compound interest is as follows:

FV = ID (1 + R)T, then FV ? ID

Where:
FV = Future Value
ID = Initial Deposit
R = Rate (interest rate earned)
T = Time (number of years invested)

Assuming the following investment--$10,000 Initial Deposit, 6% interest Rate, 5-year Time period, the math would work as follows:

FV = $10,000.00 x (1 + 0.06)5

Formula results by year are as follows:

Year 1 $10,000. 00 x (1 + 0.06)1 = $10,600.00

Year 2 $10,600. 00 x (1 + 0.06)2 = $11,236.00

Year 3 $11,236. 00 x (1 + 0.06)3 = $11,910.16

Year 4 $11,910. 16 x (1 + 0.06)4 = $12,624.77

Year 5 $12,624. 77 x (1 + 0.06)5 = $13,382.26.

Then FV ? ID = $13,382.26 - $10,000.00 = $3,382.26 (Total Interest Earned).

The effect of the individual parts of the formula in combination with each other produces synergistic results in the outcome that are greater than the sum of its parts individually. In other words, small increases in any of the components can have a dramatic incremental effect on the total compound interest earned.

Another useful tool in approximating the magic of compounding is the "Rule of 72." Albert Einstein is credited with discovering the compound interest Rule of 72 and said, "It is the greatest mathematical discovery of all time." The Rule of 72 is a mathematical way of approximating the number of years it takes an investment to double in value. You estimate the number of years for an investment to double by dividing 72 by the annual rate of return. For example, if you expect to earn a 10% return on your $10,000 investment, then 72 divided by 10 = 7.2 years for your investment to double in value to $20,000. Conversely, if you expect your $10,000 investment to double in 7.2 years and you want to know the interest rate needed, you simply take 72 divided by 7.2 = 10% interest. You can even use it to compare stock market interest rate returns to other investments. For example, assume you are looking at lots with a real estate agent. The agent tells you the properties have doubled in value during the last 14 years. You could get a quick estimate of the increase per year in value by doing the following math: 72 divided by 14 = 5.14% per year.

There is one formula that is infinitely more important than even the "Rule of 72": "1" cross + "3" nails = "4" given. Praise God!

Bill G. Page is the author of Making Money Work: A Christian Guide For Personal Finance. This book explains the "Rule of 72" and many other financial concepts. It includes a CD ROM so you can easily calculate compound interest and lots of other complicated financial formulas. The book can be ordered from www.MakingMoneyWork.us or you may request the book from your local Christian bookstore-available to retail stores through Spring Arbor and Appalachian Christian book distributors beginning in September 2005.

Bill G. Page
Making Money Work: A Christian Guide For Personal Finance (book and CD ROM)
http://www.makingmoneywork.us

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