By Landon Buzzerd, CFP®
April 5, 2024
Referred to as the eighth wonder of the world by Albert Einstein, compound interest is the ultimate example of your money working for you. Compound interest is interest calculated on both the initial principal investment and all the accumulated interest. The interest you earn on your initial investment begins to earn interest itself, resulting in growth at an accelerated rate.
To put the impact of compound interest into perspective, let’s compare it with simple interest.
Simple interest is earning interest ONLY on your initial investment. For example, a $100,000 investment earning an interest rate of 7% will result in growth of $7,000. Assuming the same annual growth rate, the initial $100,000 will earn $7,000 each year as the interest is only applied to the initial investment.
Alternatively, with compound interest, the initial investment of $100,000 will still earn the same $7,000 in year one, but the assumed 7% growth rate will then be applied to the total account value of $107,000 in year two. The result is $7,490 earned in year two, $490 more than if simple interest was being applied. The additional $490 in earnings is a result of the 7% growth rate being applied to the $7,000 earned in year one ($7,000 x .07 = $490). For compound interest to be effective, the earned interest or growth should not be withdrawn from the account. Otherwise, the interest will only be applied to the initial principal investment again, stalling any growth.
Refer to the table below which displays the difference in these two methods over a 20-year time horizon.
*This illustration assumes a one-time initial deposit of $100,000 and an interest rate of 7% per year being credited at the end of each year.
If you have ever heard the phrase “the first million is the hardest” and wondered how reaching the savings goal of one million dollars versus two million dollars could be any different, thank compound interest. As the dollar value of the investment increases, the percentage gain or interest needed to reach another milestone is reduced. Referencing the compound interest table above, it takes over 10 years for the initial investment of $100,000 to reach $200,000. However, it only takes six years to accumulate the next $100,000 and reach a total value of $300,000. We see this trend continues for each of the next $100,000 of interest earned, which is shown in the table below.
As you may have noticed from our examples up to this point, compound interest’s best friend is time. Let’s compare two people: A 25-year-old who contributes $10,000 per year into their 401(k), and a 35-year-old contributing $20,000 per year into their 401(k). They both work at the same company that does not offer an employer match, and have selected the same investments within their accounts, and expect to earn a return of 7% per year. Who’s 401(k) will be worth more at age 65?
By waiting ten years to start contributing to their 401(k), the 35-year-old employee needs to contribute twice as much just to keep pace with their 25-year-old co-worker, and even then, they fall short by more than $100,000. In other words, get started now because compound interest and time are crucial factors in the journey to building wealth.
Our examples up to this point have been about the power of compounding for investment growth, however, it’s important to understand that compound interest can work against you as well. Credit card debt can accumulate very quickly and even quicker if the outstanding bill is not paid in full each month. At the end of the month, the unpaid balance will accumulate interest, typically at an annual percentage rate greater than 20%, making that shopping spree cost more than you bargained for.
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