“Compound interest is the 8th wonder of the world. He who understands it earns it – he who doesn’t pays it.”
– Albert Einstein
What is Compound Interest?
It’s a term that a lot of people use, but not everyone understands. Compound interest is great if you are saving money, but it’s bad if you’re in debt. You need to make compound interest work for you… however; first, you need to understand what it means and how to apply it to your world.
Definition: Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. ~via Investopedia
Even to an accounting nerd like me that definition is a little confusing. So here’s a good example of compound interest when it comes to saving money:
- Save $100 and deposit it in a bank account earning 5% interest.
- At the end of a year, you will have earned interest and the account will have a balance of $105 – you earned $5 of interest!
- In the second year, if you left the money in the same bank account, you would then have a balance of $110.25 – you earned another $5.25 of interest!
The concept of compound interest is that the balance keeps on growing on itself. Every year the amount of interest you earn is more than the year before, since it is calculated on the new (higher) balance. At the end of 10 years, if you did nothing but leave that $100 in the same account (assuming there are no fees and the interest stays at 5%), you would have $171. It’s definitely the lazy man’s way of making money, but you also have to have the willpower to leave the money alone and let it grow!
Anyone Can Benefit
Once you actually see the benefits that compound interest can have on your finances, it becomes a very easy concept to grasp. You don’t have to have extensive knowledge of the stock market or financial industry, or even have a ton of money in the bank. The idea to remember is that time is on your side, the longer your money compounds the faster it will grow. That’s why starting to save early is the best thing you can do for your finances!
It reminds me of that 80’s infomercial with the slogan “set it and forget it!” That’s the key with saving and investing, put it into the account, add to it if you can, but don’t touch it and let it grow. If you put it in investments (stock, mutual funds, ETFs, etc.) in the long-term the market will give you a nice return on your investment. (That has historically been the case, but like with any investment, positive returns cannot be guaranteed, so proceed with caution!)
Continuous Saving and Growing Example:
If you were to save $5 per month in an account earning 5% interest compounded each month, and continually save $5 each month for 10 years, you will have saved $600. However, due to compound interest, the account would have actually grown to $776. Then, in another 15 years, even if you don’t add a penny, the account would be worth over $1,500 in another 15 years.
The Debt Downfall
One thing to note is that compound interest can also hinder your savings plan if you have debt. It’s great if you’re routinely saving money and can watch your money grow. However, if you are borrowing money and have debt, it can be a painful experience. Unfortunately, when you have debt time is NOT on your side. The longer you have to pay off your debt, the more interest you will owe. For example, if you have a $100,000 home mortgage with a rate of 4%, you will pay $72,000 of interest on a 30-year loan versus about $33,000 on a 15-year. (You can use this calculator to do the math for you.) It’s the same amount of debt, but when it has a shorter amount of time to compound over, the total amount you pay is less. This is also why paying the “minimum” on your credit cards will keep you in debt forever.
Low Rate, Low Savings – It Will Still Work
Although you may think that the low interest rates on bank savings accounts are discouraging, you can also invest your money in mutual funds or stocks that earn a higher return on average. Additionally, if you have a lot of debt, applying extra payments to pay down your balance, especially on credit cards, can help reduce the compounding on your debt.
You don’t need to be a millionaire to benefit from compound interest. The principle works on $100 as easily as it works on $100,000. Although having more money gives you more options, every one of us can reap the future rewards that compound interest gives us.
Sacrifice and Save
Obviously in order to put some money into savings (or pay off debt), it often requires a little sacrifice today to gain a benefit for the future. The biggest way to see your savings grow is to save even more. So doing a few things today to cut expenses or grow your income will provide a huge contribution to your savings goal.
What is the bottom line with all this talk about compound interest? It’s really the importance of saving even a few dollars a week going forward today, which may not seem like much now, but will make a big difference in your financial future.