When most of us think of making it big, we imagine ourselves creating the sequel to Facebook or being scouted to play the leading role in a Hollywood blockbuster.
But the truth is that many of the world's insanely rich sit on fortunes that have been built up over generations. In some cases over the course of a millennium (think Queen Elizabeth of England).
Although thinking that far into the future is not a common modern trait, let's break out of the box and have a hypothetical look at what time can do to your money.
Let's say you were to deposit just $100 into a savings account with a 1% annual percentage yield (yes, those do exist and you can find some examples on our savings page) and just let that money sit there for 1,000 years.
When your great (great, great, etc.) grandchildren link to the (kinetically networked) ATM of the future, they would be pleasantly surprised to find $2,095,915.56 waiting for them.
How's that possible? the answer is compound interest. It works like this: The first year that your money sits in your account you will earn 1% interest on your $100, or $1. The second year you earn 1% interest on $101 (your money plus the $1 interest you earned), or $1.01, bringing your fortune to $102.01.
Fast forward 100 years and your savings are still humble, just $270.48. Move ahead 500 years and you've got a decent $14,477.28, which still isn't much to write home (to earth) about. But 1,000 years after you handed that $100 note to the nice lady at the bank, you have become a millionaire, with a fortune of over $2 million. You will have earned $2,095,815.56 in interest (taking inflation into account, that sum may not be worth as much come Y3K).
Sure, 1,000 years is a long way into the future, but we're talking about 100 bucks at an easy-to-get 1% annual percentage yield (APY). Make that $100,000 with a 3% APY (those also exist) and in 50 years you will have $438,390.60 to blow on face lifts or pass on to your grandkids.
But compound interest is not always your best friend, and if you live on credit, the term "compound interest" probably puts a sour taste in your mouth. Somehow this elusive term seems to be responsible for those debts that we never seem to be able to pay off, and the truth is that it probably is at least part of the problem.
That's because your Annual Percentage Rate (APR) on loans will usually compound just like the APY you earn on your savings. The truth about compound interest is buried in the jargon and fine print of those lengthy loan contracts. So I'm going to throw some light on it.
Lets say you run up $1,000 of credit card debt. Your credit card has a 12% interest rate, and you figure paying back $1,120 couldn't be too difficult so you put it off till next year (when you get that raise). But when the new year rolls in you are shocked to discover that you now owe $1,254.40.
The raise never comes and you don't seem to find extra cash to pay off your debt, which by the third year has grown to $1,404.93. It just goes on from there, and the enemy you can blame is compound interest.
Using the same calculation that turned $100 in to over $2 million bucks, if you were to carry $100 of credit card debt with a 12% interest rate over 1,000 years, you'd end up with an astronomical $1,652,048,032,922,476,649,899,272,982,937,325,444,052,862,594,187,264.00 worth of debt. I would like to shorten that for you, but I don't know the going name for a 53 digit number.
Now we know why banks that have been around a long time have so much money to play with! That's the power of compound interest in action.
Be aware that there are variables in the compound interest scheme. For example, depending on the details of your account or loan, APYs (and APRs) could be compounded more than once per year.
The most common alternative to the standard 12 month compounding period is a 6 month compounding period, which is great (though uncommon) if you are earning APY on savings, and terrible (and terribly common) if you are paying interest on a loan.
Some lenders offer loans with fixed interest which isn't subject to compounding, though the rate will usually be higher.
And of course, there are bank accounts out there that do not reward you with compound interest on your savings.
Lessons: Read the fine print, ask questions, save money in an account that gives you compound interest and pay off debts as quickly as possible.
If compound interest is eating up the money that should be paying off your debts, one of the best things you can do is to use a balance transfer credit card that gives you a low interest rate (or none at all) for a long period of time.
For example, if you get a credit card that gives you a 0% intro APR for 18 months, you will have almost 2 years to pay off your debt without wasting money on interest payments. Some cards don't charge balance transfer fees, and this perk can save you serious money when you transfer a large balance.
Here are some of my favorite cards for beating debt: