How Compound Interest Works and Its Incredible Impact
Albert Einstein famously stated: "Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn't, pays it."
This may sound like hyperbole, but few understand the impact of compounding interest. The financial media prefers to discuss "sexier" topics like how to pick stock "winners," which mutual fund manager is likely to have a "hot hand," or when to get in and out of the market.
You'd be better advised to focus on the power of compound interest.
What is Compound Interest?
Compound interest is the interest you earn on interest. Here's an example provided by the U.S. Securities and Exchange Commission:
"If you have $100 and it earns 5% interest each year, you'll have $105 at the end of the first year. At the end of the second year, you'll have $110.25. Not only did you earn $5 on the initial $100 deposit, but you also earned $0.25 on the $5 in interest. While 25 cents may not sound like much at first, it adds up over time. Even if you never add another dime to that account, in 10 years, you'll have more than $162 thanks to the power of compound interest, and in 25 years, you'll have almost $340."
With compounding, you earn interest on your interest based on the principal and accumulated interest.
Simple interest is entirely different. It's calculated only on the original principal.
Here's an example that illustrates this difference.
Assume an investment of $100, with interest earned at 10%. With simple interest, here's your value in years one, two, and three:
Year one: $110
Year two: $120
Year three: $130
If your interest were compounding, you'd have $133.10 in the third year.
The difference in value between the account earning simple interest with one where interest is compounding will increase significantly over time.
The Rule of 72
You can use The Rule of 72 to calculate how your investment will grow in time due to compounding interest. You can determine how long your investment will double in value.
Divide 72 by the expected rate of return (interest rate). If your expected return is 9%, your investment will double in 8 years.
You can use this online calculator to see how your money will grow using compound interest. Compound interest calculations require:
- Your initial investment;
- The length of your investment;
- The amount of additional contribution and how often you will be making them;
- Your expected rate of return; and
- How often will compounding occur (daily, weekly, monthly, or annually)—the more frequently compounding occurs, the faster your account will increase in value.
A stunning example
Assume you have two choices:
1. Immediate cash payment of $1 million
2. A penny that doubles every day for 30 days
You may be surprised to learn that #2 is your best option by far. At the end of the 30-day period, your penny is worth a staggering $5 million.
Here's what's interesting about this example.
At the end of day 20, the penny was only worth $5,000. It increased in value exponentially in the last 10 days of the month because compounding was applied to larger values.
A negative twist
Properly understood and implemented, compound interest can play a critical role in helping you to reach your retirement goals and impact your returns. But it also has a downside.
If you are paying compound interest—instead of earning it—you will experience the negative impact of compounding.
Here's an example:
Assume you have a credit card debt of $10,000 and are being charged interest on that debt at 18%. You pay off the debt in 5 years, making regular monthly payments.
After 5 years, your total interest paid would be $5,236.
Recommendations for using compound interest
Start saving early
Assume a goal of $1 million in savings at age 65. Assume an annualized return of 7% for the entire savings period.
An investor who starts saving at age 25 will only have to invest $381 monthly to reach their savings goal. Their total amount invested would be $182,870.
What if another investor had waited a decade before starting to save? That investor would have to save $820 monthly. Their total amount invested would be $295,089.
Both investors reached their $ 1 million goal, but the younger investor did so with a lower monthly and aggregate investment.
The longer you wait, the more you will need to invest, and the higher your total investment will be compared to starting earlier.
Focus on investments that pay compound interest and not simple interest.
Typically, these investments pay compound interest:
- Certificates of deposit
- High-yield savings accounts
- Bonds and bond funds
- Money market accounts
If you have a choice, elect to have compounding calculated as often as possible.
Consult with low-cost financial advisors to know more about compound interest and how to implement it to reach your retirement goals properly.
Darrell Armuth founded Sensible in 1994. Since then, he has served hundreds of clients. Darrell is a Certified Public Accountant certified by the state of Nevada.