After reading this post, you are likely to feel two things. Firstly, enthusiasm about starting or increasing your investments. Secondly, severe difficulties to treat yourself with a pizza anytime soon. Compound interest is undoubtedly a powerful force!

Albert Einstein himself is said to have stated that “the most powerful force in the universe is compound interest”. Well, he for one ought to have known.

Most people are familiar with the concept of (simple) interest. That math is simple. If you put $100 into your bank account and the savings rate is 5 %, next year you will have $105. You withdraw the five bucks you’ve earned and share a pizza with your friend, so you are back to $100 in your account. The year after, you earn another five bucks.

The same is also applicable on loans, but the other way around. If you loan $100 at 10% and do not amortize, you will have to pay $10 a year to maintain your debt at $100.

The result in both cases is a linear curve. The chart below shows the total earnings for the pizza eating guy above. In 30 years time, his original $100 has given him 30 shared pizzas. He has earned $145 in interest (which gave him 30 shared pizzas) and still has his $100 in the bank. A 145 % return in 30 years equals almost 5 % a year. As the observant reader has noted already, we are leaving inflation out of this reasoning. We will deal with that in upcoming posts.

Well, what if this pizza eating guy had minded his diet somewhat and just said that he would put those $100 in the bank and forget about them for 30 years? What if he decided not to buy half a pizza once a year for $5, but to let the interest earnings remain in the bank account? In this way, the $100 earning him a 5 % interest the first year, would be $105 the next. The result is an exponential curve. I’m sure you can tell the difference between the chart below and the former one.

The $100 yield him 311 %, equalling about 10 % a year. And yes, the savings rate is still a meager 5 % each year. The difference is the constantly growing principal (the $100, $105, $110,25…) which each year gives 5 % back on a bigger amount of money than the year before. This is what Einstein was so excited about, compound interest!

Unfortunately, this magic is also true if you take on a loan which you do not amortize or pay interest on. Each year the principal would grow and you would find yourself in a vicious circle of indebtedness much sooner than you think. Make compound interest your friend, not your enemy!

I guess you have concluded that the guy would do a lot better to let his $100 grow without any pizza withdrawals. But what if he not only decided to let these $100 stay there, but also to skip just one pizza a year? What if he decided to add $10 a year to his savings account, although it still only offers a savings rate of 5 %? The principal would each year increase with (Principal+$10)*1,05. If the last chart was exponential, check this one out!

So, by leaving his $100 in the bank for 30 years, letting the annual savings rate of 5 % increase that amount each year and then add $10 annually, he would end up with $1,066 after 30 years. In total, he put in $290 ($100+29*$10). That yielded him 367 % or $776. For $100 and a pizza a year! And I guess you can see where that curve is heading if he lets it continue!

All the assumptions above have been made with a 5 % interest rate in a bank account. As you probably have figured out, this blog isn’t really about Income From Bank Accounts. What looks great above is nothing compared to what dividend growth stocks will give you. Trust me, I will come back to those money-making machines. For now, I settle with having demonstrated what the magic of compound interest can achieve – with a savings account and a few pizzas!

Anyone care for a pizza? Didn’t think so!