Compound interest is one of the most powerful forces of investing. It is the “interest you earn on interest” and why disciplined investors like Warren Buffett are so successful. Originating in 17th century Italy, Albert Einstein called it the “8th Wonder of the World”
Since you are earning “interest on the interest” you earned previously, it leverages your money to build more wealth. Compound interest is what allows you to grow your money exponentially.
Compound Interest Example
Let’s say you invest $100 dollars beginning of Year 1. Assuming you earn a 10% rate of return, at the beginning of Year 2 you will have $110 ($100 principal + $10 interest). In the beginning the interest may not seem like a lot, but it adds up over time. The interest you earn in Year 2 is not just on your original investment, but also the interest you earned in Year 1 (10% of $100 principal + $10 Year 1 interest = $11) giving you $121.
As the graph illustrates below, if you don’t touch that money and earn 10% again the next year, by the beginning of Year 4 your original $100 dollar investment is now $133.10. This interest continues to compound every year thereafter. The more time you have,the greater the opportunity you have to enjoy the benefits of compounding.
Assuming this rate continues, you would double your money in a little over 7 years! If we were to continue to Year 30, the interest you would earn that year would be $158.63, giving you a total value of $1,744.94! The best part about this is that you didn’t add another dime to your account or do anything to earn that money. Your initial investment was making money while you were sleeping! Compound interest is how the SMART make money.
Your initial investment was making money while you were sleeping! Compound interest is how the SMART make money.
The Power of Time
Here is another example, the graph below shows the result of $12,500 invested over 30 years at an interest rate of 8%. The initial investment amount is in green. The blue portion of the graph shows the same time period at 8% simple interest, which is interest earned only on your original investment. The purple part demonstrates the benefit of compound interest over those 30 years.
As you can see from the graph, what makes compounding interest so powerful is TIME. The more TIME you have, the greater the exponential growth.
Real World Example of Compound Interest
Warren Buffett is the greatest investor of all time and one of the richest people in the world. The illustration clearly shows that his net worth mirrors how compound interest works. He didn’t make his first billion until is mid-50s, and now his wealth as of 2019 is $86.5 billion dollars. It is never too late to start investing.
How Can You Take Advantage of Compound Interest?
Right now the maximum you can contribute to a Traditional or Roth Individual Retirement Account (IRA) is $6,000. Let’s assume your investment portfolio gives you a 12% annual return and you contribute the max ever year. In 30 years you would have over $1,627,755!
Not bad for doing nothing but being patient. That definitely is a wonder of the world! The most important thing you can do is to get started. Be disciplined, save and invest diligently, and make sure you avoid making common investment mistakes.
No matter how old you are, start saving now. The best time to invest may have been yesterday, but the second best time to invest is today. Your future self will thank you! If you need more help, here is a 14-day SMART plan that will help you get your finances on track.
The best time to invest may have been yesterday, but the second best time to invest is today.David S. Chang, ChFC®