How Does Compound Interest Work? The Eighth Wonder of the World

In this post we'll be covering one of the key pieces building wealth called compound interest.  But how does compound interest work?   Let's start with quote out there on the interwebs, and it’s usually attributed to Albert Einstein:  

What is compound interest

 

"Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.”

Albert Einstein ...maybe

Now, I don’t know if Einstein actually said that or not--but regardless of who said it, it’s the truth.  

Compound interest is powerful.  And the earlier you start to harness its power by putting your money to work for you, the better off you’ll be.

compound interest

How do you define compound interest?

Simply put, the compound interest formula is interest on an investment or liability that is calculated against the principal AND all previously accrued interest.   This is different from simple interest in which the interest rate is applied against the principal only.  

It's a small nuance with big impacts. So not only is your principal making money, in addition-- the money your principal made is ALSO making money.  That’s very cool stuff.

In case you were wondering....

The Standard & Poor's 500, aka the S&P 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.


 Like any investment, it's size fluctuates constantly, and past performance doesn’t predict future results, but it is a strong indicator. Feel free to use another percentage if you like.

How does compound interest work in a 401k?

Let’s look at some examples. For the sake of easy math, assume you have $1 to invest in your 401k with a fund that has averaged a 10% annual return over the past 30 years. It’ll be a few years until you’ll need it, so you might as well let it grow.


Example #1:  The Effect Of Compounding Interest On  $1

YEAR

PRINCIPAL INVESTMENT

ENDING BALANCE

One

$1.00

$1.10

Two

$0

$1.21

Three

$0

$1.33

Four

$0

$1.46

Five

$0

$1.61

Six

$0

$1.77

Seven

$0

$1.95

Ten

$0

$2.59

Twenty

$0

$6.73

Thirty

$0

$17.45

You’ll see the effects of compounding interest over time, beginning  as early as year 2--and the magic really kicks after 10, 20, and 30 years.  

If you left that $1 in this investment for 30 years, over time as a result, with compound interest you would have $17.45.  

Sweet! 

And keep in mind, you didn’t contribute anything beyond the initial $1 investment.

Let’s see what would happen if you added just $1 per  year, or $30 over 30 years.


Example #2:  The Effect Of Compounding Interest On  $1 Invested Annually

YEAR

PRINCIPAL INVESTMENT

ENDING BALANCE

One

$1.00

$1.10

Two

$1.00

$2.31

Three

$1.00

$3.64

Four

$1.00

$5.10

Five

$1.00

$6.72

Six

$1.00

$8.49

Seven

$1.00

$10.44​​​​​​​

Ten

$1.00

$17.53

Twenty

$1.00

$63.00

Thirty

$1.00

$180.94

With compound interest, in 30 years, your investment would have grow to nearly $181 with just $30 of investment.

Want to hear the coolest part of all? You have this power at your fingertips RIGHT NOW!

Seriously. You can set up an investment account and start saving today, invest a few dollars in a S&P Index Fund, and leave it alone.  Compounding interest will take care of the rest.

Now admittedly, this illustration oversimplifies the “how, when, and where” of investing, which I’ll cover in a greater detail in a future post. But it definitely covers the “why.”

The more time you have to allow for your balance to grow (say 10, 20 or 30 years) the less investment you need to make to see exponential returns.  

So which would you rather have?

Option A: $1 a year starting today

-or-

Option B: $181 in the future

I’m for B.

If you want to game out some other scenarios, moneychimp has an excellent compound interest calculator you can try for free.

How to maximize compound interest

First, you need free cash flow that you can invest, and the confidence that you can leave it invested. For that, you need a budget that works.

Therefore, the sooner you pay off debt and take control of your financial destiny, the sooner you can start investing and benefiting from the wonders of compound interest.

To help get rolling, I'd recommend starting with this guide for the basics of personal finance, which covers how to...

  • 1
    Get Organized and In Control
  • 2
    Get Protected From The Unexpected
  • 3
    Pay Off Your Debt
  • 4
    Invest For Your Future
  • 5
    Don't Stop Dreaming

Now that you know the answer to how does compound interest work, are you ready to start investing?  The sooner you start investing, the longer you have to benefit from it's power to create the financial future you want.  

If you are already utilizing compound interest to your benefit, please share your motivating successes in the comments below!  Any tools, tips for others ready to start investing?

About the Author

Hello, I'm Ryan Rollins. I've been passionate about personal finance and entrepreneurship for as long as I can remember. After earning my Bachelors of Science in Marketing, I soon found myself at my first software start-up. That experience led to me pursuing an MBA in Entrepreneurship from the University of Louisville, and eventually to a career in product management within the financial services industry, where I've spent the last 8 years focusing on financial education and consumer lending. When I'm not working I enjoy spending as much time as I can with my amazing family, going for long runs around the neighborhood, and develop a portfolio of passive investments and income streams. You can also follow me on twitter @TMPF_Ryan

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