Compound interest vs simple interest is a basic concept for most of us dividend growth investors. But I realized while talking with colleagues about my strategy that some didn’t understand the huge difference between the two.
So let me explain that with an example.
Julie buys a 10 years investment of 10,000$ with a simple interest of 5% per year while John buys an investment of 10,000$ with a compound interest of 4,5% per year. Which investment do you think will be more profitable?
Let’s do the math.
With a simple interest of 5% per year, Julie will be credited 500$ in interest after year one, 500$ after year two, 500$ after year 3 and so on until the 10 years term expires. At the expiration date, she will receive her capital of 10,000$ plus (500$ x 10 years) 5000$ in interest.
John on the other hand has a more complex situation. After year one, he will be credited 450$, after year two, he will see his account credited with 470.25$. After year three, he will see his account credited with 491.41$ and so on. After 10 years, John will receive his 10,000$ back plus 5529.69$, an extra 529.69$ more. Not bad since he had a rate of 4.5% while Julie had a rate of 5%.
How can that be possible?
It’s pretty simple actually. Simple interest is always calculated on the initial amount of capital while compounded interest is calculated on the capital plus the interest of the previous years. So Julie will always get 5% of 10,000$ or 500$ while John will receive a different but increasing amount every year. His interest will be calculated on 10,000$ after year one so he will receive 450$ or 4.5% of 10,000$. But on year two, he will get 4,5% of 10,450$ or 470.25$. Every year, his amount of interest will grow and grow. His last interest deposit on year 10 will be 668.74$.
Dividend growth investors love compounded interest because it applies to both their capital and their income. When I buy a stock, my goal is to get an initial yield of 3.5% or 350$ per 10,000$ invested. And I want this 350$ to compound at a rate of 8% per year on average. So on year one I will get my 350$ bucks in income (dividends) but on year two, I will get 8% more or 378$. On year three I will receive 408$ and so on. That’s how you transform within a period of 14 years, 350$ bucks of income into 1028$ of income that will continue to compound. After 20 years, my initial investment of 10,000$ will provide me with 1631$ in income, 3521$ in income after 30 years and 7600$ after 40 years.
Let’s take my personal situation. Last year, I have invested 30.000$ and I have reached 1065$ in dividends. If I would stop investing but keep my investments forever until I die, I would receive 2300$ in income after 10 years, 4964$ after 20 years, 10717$ after 30 years and 23136$ after 40 years… that would make me a 73 years old guy…
Compounded interest is very powerful but it takes time for it to deliver its true magic. After 20 years, usually things are growing at an unbelievable rate!
I love compounded interest and you should love it too. That’s how you can build a fortune, one dollar at a time. Eventually, your money will work for you and you’ll be able to quit your day job.
If possible, I’d like to quit my day job within a 12 years time frame over my dividend and online income. I still have a lot of work to do before being there but I know understand that time is money and that every dollar count.
Do you have a retirement plan or strategy? At what age do you plan to retire?
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