Compound InterestYou know what drives me crazy? The completely inferior education being given to those talented children enrolled in Hogwarts School of Witchcraft and Wizardry.

Yes. They are magic children, but does that mean that they don’t need any training in language or math? Does science cease to be relevant if you can conjure matter out of thin air…. Or does it just get super interesting?

And the subjects they do take… what jobs are they being prepared for? Why is care of magical creatures REQUIRED for the first 3 years?! That has senior elective written all over it.

What they should really be teaching is the kind of practical magic that they’ll use every day of their adult lives.

Like the magic of compound interest.

You can believe me or not, but something that outwardly may seem pretty mundane is just as magic as anything you’d learn in a charms class.

Don’t believe me… well let’s start with some basics.

What is interest?

Interest is the ‘fee’ that you get paid if you lend someone your money. It’s inconvenient to not have your money, so when you give it to someone it’s natural to expect something in return… to repay you for that inconvenience.

So whenever there is a debt, or a lending of any sort… there is also ‘interest’.

You get it in your savings account, you see it applied to your credit card, it is a key part of your life… whether you know it or not.

Let’s start with the simple….

The most basic form of interest is ‘simple’ interest.

Let’s say Harry lent Ron 100 muggle dollars (I’m not going to use wizard money in analogies… because I have no idea what the ratio of knuts to sickles is….). Harry gladly gave his friend the money but insisted that he pay him 10% interest every month… until he got his muggle money back (which is kind of a jerk move since they’re best friends… but hey… it makes for a good lesson for you).

They agree that Ron will pay him with his birthday money one year from now… so here’s how the interest boils down over that year.

Compound Interest ChartIt’s simple. One year from now, Ron will pay Harry back 220 bucks, and while he might be questioning the true cost of being a sidekick, it’s pretty easy to understand the bill: 10% per month.

That’s why it’s called simple interest.

The magic of compounding

The magic starts when we add the word compounding.

So. At the same time Ron goes to Hermione for the same loan. Muggle cash.  100 dollars. Paid back in a year. But Hermione is different… she’s wicked smart (like, Ravenclaw smart) and offers the same deal as Harry, but sneaks the word ‘compound’ in there. Ron, with no awareness of the mess that he’s getting himself into (due to the terrible educational standards of his chosen institution) quickly agrees.

Here’s what happens…

Compound Interest Chart 2

Wait. What’s happening….?

Compound interest means that you’re paying interest… on the interest… instead of your interest payment just applying to the ‘original amount’ of 100 dollars (like in the simple interest). As Ron’s monthly interest payments get added to the pot, the next interest payment gets applied to the NEW POT, not the original amount.

So instead of a slow… steady growth… we get something exponential.

And when one year from now Ron walks up with the 220 dollars he expected to pay her… he’s hit with a much bigger bill.

He get’s mad… but Hermione gets very rich.

Back in the muggle world

I’m not suggesting you go out there and try to trick your friends into overpaying you for loans. But to realize the immense power that compounding can have, you should understand this simple rule:

Time, when combined with compounding, is freaking unstoppable.

In the real world of finance, we don’t have anyone paying us 10% a month. That’s crazy. But even when the numbers are smaller, they grow over time. And the more time that you can give that small amount of money to grow… the more it can become.

Look at this Math chart. 100 dollars were invested in the bank. They both received 8% per year, one was paid with simple… one with compound….

Try telling me that’s not magic.

100 dollars, over 40 years… becomes more than 2000 dollars.

Think of 1000 dollars over 40 years, or if you were constantly contributing to that nest egg.

THIS IS HOW PEOPLE BUILD WEALTH. And the earlier you start, the more it has time to grow.

The best time to plant a whomping willow was 20 years ago, the next best time… is right now.

One of the biggest things you should take away from learning that there’s really magic in the world and its name is compound interest, is that the sooner you start saving… the bigger your rewards will be.

In the first 20 years or so, it works slowly, the biggest gains are in the last 10 years.

This is not a tool that’s only available for the rich, it’s something we all can enjoy… if we put ourselves in the position to take advantage of it.

So start saving as soon as you can… not so you can feel more like an adult… but so you can be a real life wizard.

He Who Must Not Be Named: the dark side of compounding

If you look at our Ron/Harry/Hermione example… it’s good to be Harry, it’s great to be Hermione… but you don’t want to be Ron.

Compound interest can be your best friend if you’re the one on the receiving end, but if you’re paying it… it cuts just as deeply.

That’s why the credit card companies are doing so well… and why if you just maintain a minimum payment you never seem to make any progress.

Like any magic, compound interest isn’t good or evil… it’s just a tool.

You get to decide how you’re going to use it, or be used by it.

You can’t afford to wait.

The average artist, the average freelancer, the average person isn’t pulling down millions of dollars. Life costs a lot and it’s hard to get by. It’s even harder to imagine things like ‘retirement’, or any funding of old age, especially when that all seems like it’s years away.

As much as you may feel like you can’t afford to save in your 20s and 30s… I’m telling you that you can’t afford not to.

The magic of compounding means that if you put your money in the right situation to grow, and give it enough time… you can turn a very small seed… into a very large, most likely magical … life.

Start learning real world magic, it’s what Dumbledore would have wanted.