Investing has many benefits. One of them, and maybe the biggest, is compound interest. It is a very powerful “force” that allows your savings and other investments (including stock or retirement) to grow at a rapid rate. Learn more below about compound interests as well as examples of it, how it works, and the benefits to investing early and often. Albert Einstein said compound interest is the “Eighth Wonder of the World” as the concept is so powerful.
Setting money aside in a savings account or investing in the stock or bond market is a worthwhile practice at any age, especially for younger investors such as someone first entering the job market or a teenager. It is important to do for long term financial success, and investing is an important financial literacy skill. Now compound interest, when combined with investing, is often called the 8th Wonder of the World and it is a powerful tool.
Most people understand that interest is the money an investment earns, and the higher the interest rate, the more your money earns. There are different types and methods of calculating interest, but surveys indicate the majority of Americans cannot explain the difference between simple and compound interest. Understanding how compound interest works can make a significant difference in the long-term value of your savings and investments. it can help your children, teen or middle school or high school student get rich too – if they start investing early enough.
Simple vs. compound interest
Simple interest is money earned solely on your principal investment. For example, if you place $500 in a savings account with an annual simple interest rate at 5%, at the end of one year your account will have earned $25 interest and have a total value of $525. The original $500 deposit is called the “principal”, and the interest of $25 is your earnings. Assuming you leave the account alone, it will continue to earn $25 per year in interest which is calculated solely on the principal investment. At the end of 4 years the account will total $600.
A compound interest account calculates interest not only on the principal but also on the interest earned or appreciation of your asset, such as a stock. Depositing $500 into an account with an interest rate of 5% compounded annually will still earn $25 during the first year resulting in a total at the end of one year of $525. However, beginning in the second year interest will be calculated based on the total of principal plus interest in the account. All $525 is subject to the interest calculation, so the interest earned the second year is $26.25, and your account totals $551.25. After four years the initial deposit of $500 is now worth $607.75.
The exact same financial literacy concept of compound interest applies to the growth of stocks, bonds, ETFs, or mutual funds too. Buying $500 of a stock or equity investment with a return of 5% compounded annually will still earn $25 during the first year resulting in a total stock worth at the end of one year of $525. However, beginning in the second year return of the investment will be calculated based on the total of principal plus previous year(s) return. All $525 of the stock market investment is subject to the compound calculation, so the growth of the investment earned the second year is $26.25, and your account totals $551.25. After four years the initial investment into a stock, bond, or fund of $500 is now worth $607.75.
In a compound interest account, you earn interest on your interest or return of your stock or other investment. It is one of the most important concepts to learn about investing, building wealth, and financial literacy. Compound interest allows almost anyone, even a low income family or someone saving few dollars at a time, to build wealth. Compound interest is most effective when someone invests early as well as on a regular basis, and this is why a teenager, college student, or someone just entering the workforce needs to invest.
In simple interest accounts, the annual earnings remain the same. The $500 savings account will earn $25 year after year. In a compound interest account, the annual amount of interest earned will increase every year since it is calculated on a constantly growing total of principal plus all accumulated interest to date.
Factors affecting compound interest amounts
Everyone generally understands that, regardless of the type of interest paid or growth of the investment, the higher the interest rate or growth, the more an investment earns and is worth. With compound interest accounts, several other factors take on greater importance. Making regular deposits to a compound interest account or the stock market will result in faster value growth than experienced in a simple interest account. Time becomes an increasingly critical factor and important to building financial assets. The longer you leave the money alone, the more dramatic the account growth will become.
The frequency of compounding can have a significant impact. Most bank accounts typically compound interest annually. Stocks and other investments will compound annually by default. However, compounding can take place with greater frequency such as semi-annually, quarterly, monthly or daily. A higher number of compounding periods increases the amount of money as well as compound interest earned. Using the $500 example above, if interest is compounded twice a year rather than annually, at the end of four years the account value increases from $607.75 to $609.20. Quarterly compounding raises the total to 609.94.
Compound interest is making your money “work for you”
Lets say you have $100 to your name, and on March 1, 2018 you buy a tax-free municipal bond fund that is paying out 4% per year. Sounds simple enough. So what happens then?
To keep it simple, lets say the 4% dividend is paid out one time per year, on February 28, 2019. Compound interest means you take that $4 in dividends and you re-invest it, which will then increase the balance of your account. So on March 1, 2019 you now have $104 in the municipal bond fund account ($100 initial investment + $4 in interest).
Then the interest is paid out again on February 28, 2020, and this time instead of making $4 in interest, you make $4.16 in interest. You made a little more money in interest as your account balance was $104 on February 28, 2020, and that was the calculation used to determine the payment. In year two you therefore made $4.16 in interest rather than $4 like you did in year #1 as you continued to let the interest on the initial investment be re-invested.
At its core, that is what compound growth is. It is making your money work for you by reinvesting the gains. While all of this may not sound like much money or make a big difference (as what is an extra 16 cents!) the key is to let the money compound over the years.
Using that same $100 investment made on March $1, 2018, and using a 4% interest rate, compound rate of return will look like this.
This tells you that in 8 years your initial $100 investment is now worth $136.86. Your initial $100 investment worked for you and earned $36.86 for you…without you having to do a single thing. You could have sat on the couch and still made that extra money.
The effects of compound interest continue to build and the amounts grow even more over time. Or, if you were to invest a little more money and/or earn a slightly higher rate of return, then the results are even more impactful. Lets say you invested $1000 in March 1, 2018 at the 4% return, the results would look like this.
That is $368.57 your investment “earned” for you!
And if you invested $100 on March 1, 2018 and received 7% returns/interest per year (say a stock based investment instead of bonds) the results would be.
You therefore earned $71.82 as the result of compounding! And did not even need to lift a finger for that money. Now instead of $100 as an initial investment, you can use that as a baseline and multiply it by different amounts to determine how much you would have earned from compounding by a larger initial investment. For example, if you initially invested $1000, take that $100 multiple it times ten (and the $71.82 x 10 as well) and you would have earned $718.20 as the result of compounding interest.
No wonder that Einstein called compound interest the “Eighth Wonder of the World” as it can have such a powerful result, though the concept is so simple. The key to make it work is to save and invest as early as possible. Even if you are lower to moderate income, the key is save a little money each money, and let the interest, dividends, or capital gains continue to be re-invested year after year (compound) and let the balance grow.
The snowball effect of compound interest and time
The greatest advantage of compound interest comes from beginning to save or invest at an early age and adding to the principal at regular intervals. It may be the most important and powerful financial literacy skill to learn. Save/invest early and often to gain exponential growth. Kids and teenagers should take advantage of the power of compound interest and their investments, including stocks or mutual funds. There are even financial literacy apps for kids to help them invest.
Time is your greatest ally when investing in any interest-bearing account or stock but particularly when compound interest is involved. A few examples demonstrate how even a minimal investment with regular small deposits generates increased value over time.
Compound interest or rate of return is also used as part of the Rule of 72. This is a quick equation that will help you determine how long it will take your money to double in value. It is as simple as dividing 72 by the rate of return that your investment gets. The answer to that is the number of years it will take to double your money. So if your stock or mutual funds returns 9% per year, and if it grows on a compound basis, then you would go 72/9 equals 8 years to double. Learn more on Rule of 72 doubling your investment.
The One Time Investment. At the age of 16, you deposit $1,000 into an account that compounds interest at 5% annually, and you never withdraw any funds or make additional deposits. Or you bought $1000 in stock that grows (has a return) of 5% per year. Just by leaving the money alone your account will grow to $1,620 in ten years. When you turn 36 the account will be worth $2,653, and at age 66 the original $1,000 investment you made 50 years earlier will be worth $11,467.
Regular Small Deposits. You get your first job at the age of 16 and begin to deposit $20 each month into a bank account earning 5% interest compounded annually. Or you invest $20 each month into the stock market and your investment returns 5% per year.
10 years later, the account will be worth $3,170. Continue these small deposits or investments until age 36 and the account grows to $8,333. If you can maintain the practice of setting aside just $20 a month until age 66, your account will grow to $52,756. Consider the potential if you can increase the dollar amount of your monthly deposits. This is why it is critical to save/invest early, even as a kid or teenager
One Time Investment Plus Regular Deposits. At the age of 16, you make a $1,000 deposit into a similar account, but since you recently started your first job you add $50 a month out of your pocket. In 10 years the combination of added deposits plus interest compounding or growth of your investment on the ever-increasing balance will result in the account totaling $9,553. Invest in high school and college, and keep that routine going for 20 years and the account grows to $23,485. At age 66 you will have an account valued at $143,357 of which only $31,000 resulted from your monthly deposits. The remainder is accrued interest.
The Middle Age Investor. Life frequently gets in the way of saving. Even if you were unable to save while you were a kid or went to college, launched a career, got married and started a family, beginning to save at age 30 can still result in a valuable retirement nest egg. Setting aside $100 a month beginning at age 30 in an account paying compound interest at 5% annually or a stock that returns 5% per year, this would provide an account worth about $113,804 at age 65. Only $42,000 would have come from your pocket with the rest being interest.
If it this snowball effect of a small initial investment that grows exponentially with time that is referred to as the “magic” of compound interest. Albert Einstein called it the eight wonder of the word. To create specific savings scenarios similar to the above examples, you can find numerous easy-to-use interest calculators online at various financial literacy websites. You just need to input the amount of your initial investment, the amount you plan to add annually, the rate of interest, the number of years you will allow the savings to grow and the number of times interest is compounded annually.
The negative effect of compound interest on debts
Understanding the concept of compound interest should not only help earn more money from savings and investments, but it can also help you save money paying off loans and credit card balances. Just as compounding interest works in your favor for investments, it works to your disadvantage and in favor of the lenders when you owe money on credit cards, mortgages or student loans. Interest on these types of debts is typically compounded monthly. Knowing how compound interest impacts such debts shows why it is important to pay more than the minimum monthly amount on these accounts.
For example, if you maintain a credit card balance of $2,000 with an annual interest rate of 20% and do not make any payments, the amount of interest added to the account will grow each month. At the end of a year, the added interest would total about $439 or an average of about $36.58 a month.
When it comes to bills, your plan should be to pay them off quickly by paying more than the minimum monthly payment. Paying the minimum may keep you in the good graces of credit reporting companies but will cost you in the long run, since you are likely only making a minimum reduction in the underlying debt.
Examine your monthly credit card or loan statements to see how much interest was added that month and then pay as much as you can afford above and beyond the interest charge. By doing so you will reduce the principal debt which will result in a smaller interest charge the following month. You can also make a greater dent in the principal debt in many cases by taking the same amount you would pay monthly and split it into two payments, one every two weeks
Getting started to benefit from compound interest
The earlier a person begins to save, the better the potential result. Parents can set up a savings or even an investment account for a child and make small monthly deposits until the child is old enough to grasp the concepts of savings and interest. Invest in the stock market to show a teenager how compound interest can help them investment, and assets, can grow exponentially in value. Help them learn about financial literacy and saving/investing at an early age.
Once a child begins to earn an allowance or a small income from doing chores, the child can be encouraged to add to the account and watch it grow. Let the kids and help them learn about saving as part of financial literacy. If a savings or investing habit can be instilled at a young age, once the child reaches teen years and starts to work outside the home, the teen can begin saving a greater amount with the potential of many years to accumulate interest.
Spend some time looking for the best interest rate you can find. Or invest in an S&P 500 index, which will also increase in value over time from compound interest. Just do something to get started on building this financial skill….do not let time pass by. We have have information on teaching children and teens financial literacy skills.
Most brick and mortar banks pay pretty low rates. Online banks typically offer interest rates two to three times higher since these banks don’t have the overhead cost from operating at physical locations. Even at a low interest rate, when money is compounded frequently and left alone, the end result can still be impressive. If you invest in a stock that compounds, the benefits can be exponentially higher. Whether you are searching for a savings account, stock investment to buy, a certificate of deposit or a 401(k), all of those can help you grow your wealth. Even more so the earlier you start.
Regardless of your investment choice (stocks, bonds, CD, savings, etc.), the important step is to open an account that features compound interest and then make additional deposits on a regular basis. The earlier in life you begin, the more impressive will be the results you obtain. As the fact is, compound interest may be the only fail safe way to build wealth and assets over time.
By Jon McNamara