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:
"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.
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
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.
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
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
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
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...
- 1Get Organized and In Control
- 2Get Protected From The Unexpected
- 3Pay Off Your Debt
- 4Invest For Your Future
- 5Don'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?