Understanding Compound Interest and How It Can Build or Destroy Wealth
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Have you found yourself asking “what is compound interest?” If so, you’re in the perfect place to learn everything you need to know about calculating and earning interest on your interest.
People like to use mountains as a metaphor for investment planning and retirement saving. As you contribute to your nest egg, you climb the mountain. The more you contribute, the higher you climb.
Eventually, you reach the top of the mountain and retire. It’s a simple, elegant way to describe the journey of building a secure financial future.
But it can also be helpful to turn that metaphor upside down. Think of your retirement account as a snowball rolling down a mountain, gathering snow and growing larger as it rolls.
The more time it has to roll, the bigger it gets, and the bigger it gets the more surface area it has to collect even more snow. That’s how compound interest works.
If the concept still seems a little hazy, don’t worry. This definitive guide to compound interest will teach you how it works, when it matters, and how you can use it to your advantage.
What is Compound Interest?
Compound interest can be a confusing concept to understand, but the definition is simple. Compound interest is the financial concept of earning interest on interest. It explains how people set aside a small amount of their paycheck and collect huge returns decades later.
Compound interest occurs when you put money in an account where it receives a return on investment. As time goes by, the money in that account will earn interest. That interest will then be added to the principal, and new interest will be calculated based on that new principal. It’s like a snowball effect that happens when money and time mix.
For example, an account holding $1,000 with an 8% interest rate and annual interest compounding will have $1,080 after one year. After two years, it will have $1,166.40. The interest accrued during the second year has increased because it was calculated based off of $1,080 rather than the initial $1,000.
Compound interest visualized
Enter different scenarios into the compound interest calculator below to see the power of compounding interest.
The difference between simple and compound interest
There are two ways to calculate interest: simple and compound. Simple interest is calculated based only on the principal. If you have $500 in a savings account with 1.5% interest, you’ll earn $7.50 interest every year. The interest amount will always be $7.50 because the interest is only based on the principal.
As we discussed in the previous section, compound interest grows based on the principal and the interest. If you have that same $500 earning 1.5% in an account with compound interest, you’ll earn $7.50 interest the first year. The new total will be $507.50 and interest will now calculate on this amount. In the second year, you’ll earn $7.61 and so on.
It’s very rare to earn simple interest on a savings account or investment, though some bonds do pay simple interest. Some auto and personal loans will also charge simple interest to customers.
The compound interest formula and the rule of 72
The rule of 72 says that to figure out when your money will double with compound interest, divide 72 by the interest rate.
For example, if you have $5,000 in a savings account earning 2% interest, it will double in 36 years. If you put the money in an IRA with a 5% return, the money will double in 14.4 years. This rule highlights how much the interest rate matters when it comes to investing.
As a calculation, it’s still pretty rudimentary. It doesn’t take into account how much you contribute to the principal or if the interest rate varies as it does with investment accounts. It’s helpful to use the Rule of 72 when you’re trying to explain or understand compound interest, but don’t rely on it to make complex financial decisions.
Thankfully, you don’t need to perform any complex calculations to figure out how your investments will compound over time. Our compound interest calculator can do it for you.
Compound Interest Examples
These examples will show you just how compound interest relates to things in your daily finances like credit cards, investments, savings accounts, and more.
When people talk about the power of compound interest, they’re referring to the powerful earning it allows over time. But in the same way compound interest can work for an investor, it can also work against a debtor.
If you’re carrying a revolving balance on your credit cards, you might not realize how compound interest affects you. Let’s say you have a $1,500 balance on your credit card with 16% APR.
You pay the $25 minimum every month. Because the payment goes mostly toward interest, it takes you 122 months, or 10.2 years, to pay off the entire balance. During that time, you pay $1,537.88 in interest — more than your original principal.
Every time you make a payment, you only pay down a small portion of the principal. When interest is determined the following month, those calculations are based on the remaining principal and interest.
To reduce how much you pay in credit card interest, you can either make larger payments or transfer your balance to a card with a lower annual percentage rate (APR). By only making minimum payments, you increase the effect of compound interest on your debt.
It may seem impossible to save the recommended $1,000,000+ for retirement if you aren’t bringing in at least six figures every year, but compound interest makes it possible for almost anyone. Even someone making a modest salary can build an enormous nest egg as long as they do two things: start investing early and contribute as much as possible.
Here’s how it works. Let’s say you’re 22 years old and just landed your first real job out of college. You’re making $40,000 a year and can afford to save $100 a month toward retirement.
You open an IRA and start automatically depositing $100 every month. After one year with 7% returns, you have $1,242.87 in your IRA. That means you earned $42.87 in interest.
You keep saving $100 a month for the next five years with the same rate of growth and now have $7,183.20. You’ve earned $1,183.20 in returns.
Now, you’re 27 years old and your boss gives you a big promotion, so you can afford to bump your savings to $200 a month. In 30 years, you’ll have $304,288.31.
Here’s where compound interest makes a difference. Let’s say that instead of saving $100 a month from ages 22-27, you decided to hold off until you had a bigger salary. If you waited five years to start saving for retirement, you’d only have $245,640.89 at age 67 — a difference of more than $50,000.
In short, the best time to start saving for retirement is right now. Even if you can only afford to invest $25 a month, it’s still worth opening an account. Compound interest becomes more powerful the longer you invest, and starting early will make it easier to develop a robust saving habit.
Fees on investments
Compound interest can sometimes work against you, especially if you’re paying high fees on your investments. Most people invest their retirement savings in mutual funds, which charge fees to pay for fund management.
On top of those built-in fees, some consumers hire outside advisors to manage their retirement savings. Unfortunately, many of these managers waste their client’s money with excessive fees.
Active managers often charge a percentage of their client’s total assets, usually around 1%. This doesn’t include any fees in the funds the advisor recommends, which can also equal around 1%.
Paying 1% in fees for someone to manage your money might seem like peanuts, but it adds up quickly. When you’re saving for retirement, a good rule of thumb is to estimate 6-7% growth each year. If you’re paying 1% in extra fees when you could be paying .15%, you’re giving up a huge portion of your earnings, likely hundreds of thousands of dollars.
That’s why fee-only financial planning is so crucial. A fee-only planner is one who charges a flat fee for their services, usually a few hundred dollars per planning session. They give recommendations on how to invest your money and typically focus on low-fee investments.
Examine your investments and determine their expense ratio, meaning the percentage you’re paying in fees. Some brokerage firms, such as Vanguard, offer funds with lower fees if you can afford a higher minimum.
If you have a savings account, you’re probably used to earning pennies a day in interest. It may not lead to the same results as an investment account, but savings accounts also benefit from the power of compound interest.
Compound interest on a savings account works just like it does for an investment account, except the interest rates are usually much lower. If you have a $10,000 emergency fund at a low-yield savings account at .05% interest, you’ll earn $5 the first year. In five years, you’ll have earned $25.03 in interest.
If you switch to a savings account with 2% interest, you’ll see a huge shift in total interest earned. After one year, your account will be worth $10,202.01. After five years, you’ll have $11,051.68.
This is why finding the highest interest rate possible is crucial, especially when you’re saving for the long term. If you keep that emergency fund around for a decade, you could lose out on $2,163. Keeping your money in a high-yield savings account isn’t associated with any increased risk, so there’s no reason not to.
Companies pay dividends to share their profits and entice more investors, like an extra tip or bonus. When you invest in mutual funds that pay dividends, you have the option to reinvest those dividends into your investment account.
If you reinvest dividends, the money is used to purchase more shares of that mutual fund. This means you get to increase your stake in the company without contributing more of your own money.
Reinvesting also increases how compound interest affects your investment. When you reinvest the dividends, you increase your total invested amount, which then leads to bigger returns.
Go through your mutual funds and make sure you’ve selected the “reinvest dividends” option. You might have to call your brokerage company to make those changes if the option isn’t available online.
How to Make Compound Interest Work for You
The best way to take advantage of compound interest is to increase your savings and interest rate on your investments, while at the same time decreasing the interest rate on your debts. You want to maximize the benefits you receive from compound interest and minimize the drawbacks.
Make a list of all your savings and investment accounts that earn interest. Write down the total balance, monthly contributions, average interest rate, and any fees. Look online to see if you could be earning more in interest or paying fewer fees. For example, if you have a checking account that doesn’t pay any interest, see if you can switch to a bank that does.
Maximizing compound interest is also about starting a saving habit as early as possible. If you’re not yet saving for retirement or other goals, you need to make that a priority. Contribute as much as you can afford and increase the amount when possible.
The Power of Compounding Interest
Compound interest is powerful because it shows how small, consistent habits can transform your finances. It’s comforting to know that when facing a challenge as daunting as retirement planning, what really matters are the small, everyday choices.
Even if you’ve struggled to understand the concepts outlined above, the only takeaway that really matters is this: If you decide to only pay the minimum on your credit cards, you’ll be in debt longer. If you pay more than the minimum, you’ll repay the loan faster. If you wait to start contributing to a retirement account, you’ll retire later. If you start as soon as possible, you’ll retire sooner.
Start saving now to make compound interest work in your favor.