Compound interest refers to interest on your initial investment as well as interest on your interest. Einstein calls it the 8th wonder of the world, and it will play a critical role on the road to achieving your financial dreams.
To calculate compound interest, use the formula:
A = P x (1 + r)n
A = ending balance
P = starting balance (or principal)
r = interest rate per period as a decimal (for example, 2% becomes 0.02)
n = the number of time periods
What Does Compound Interest Look Like?
If you placed $1,000 in a bank account at an interest rate of 5% after 12 months, it would return $1,050. The $1,000 is your initial investment, and the $50 is your interest, simple enough, but what if you invested $1,000 for 5 years? What interest would you expect to generate over that period? If you think the answer is $250 you might be surprised to learn that you would actually receive $1,276.28 after 5 years. Where does the extra $26.28 come from you ask? Compounding!
In the example above, you may have anticipated $50 a year in interest but you need to realise that after year one you are not reinvesting $1,000 but $1,050. This means that while you earned $50 interest in year 1, you will receive $52.5 in year 2 (1,050*1.05 – 1,050) and $55.13 in year 3.
$26.28 may not seem like a big deal, but here’s the good news. When you invest for long periods, and you continually add to your principal, compounding can provide you with fantastic returns.
Below is an example of what compound interest looks like against simple interest on a $1,000 investment over 10 years.
One of the most amazing things about compounding is that it helps everybody, not just people who are already rich. In fact, compounding heavily favours time over money. This means that if you put in the effort and regularly invest for long periods, you will be rewarded far more than somebody who invests a lot more than you over a shorter period. Let’s consider the following example:
In the case above, the person who starts investing at 35 commits $130,000 over 25 years but finishes with almost half the money as the person who invests $55,000 over 10 years and lets their money grow untouched for another 25 years. That is the power of compounding!
How Do You Take Advantage of Compounding?
Start early, there’s an old Chinese proverb that states ‘the best time to plant a tree is 20 years ago. The second-best time is now’. Investing is much the same, the earlier you start, the higher the returns you will see. This doesn’t mean that if your 35 or older you shouldn’t bother, the 35-year-old person in the example above was still able to generate $470,000 in returns on their $130,000 investment. The point is, the sooner you start, the more time you allow compounding to work for you.
There are only two steps to taking advantage of compound interest, save and invest. The more you can save, the larger your returns will be. If you consider the above example with the 25-year-old who was able to turn $55,000 into $1.1m over 35 years, but this time they never stop investing the final value of their account would have been close to $1.65m. If they were then able to increase their investment from $5,000 to $6,000 per year, their account would have grown to a touch under $2m. The second component is making smart investments. Compounding can have a more substantial impact when the interest generated on your investment is higher. If the 25-year-old investor was to have placed his $55,000 in a savings account paying 4% his final account value after 25 years would have only been $187k. If he was somehow about to achieve 12%, his $55k would have become $1.97m. For these reasons, if you are investing for the long run and can handle the volatility in the short-term, it is best to invest your money in higher return investments like stocks as opposed to savings accounts.
The lesson is: Invest early and often.