Since I have become fully immersed in the journey to my own financial independence, one of my biggest regrets has been not taking more advantage of compound interest. It is the one area of personal finance that really needs to be taught in schools and impressed upon our children. Had I understood the power of this simple mathematical tool when I was younger I would be far better off financially today. Hopefully this article will impact you the way I wish someone would have done for me when I was a teenager.
What is compound interest?
In its simplest form, compound interest can be defined as interest earned on interest. It is the result of re-investing interest paid on a principal so that the next period interest will be paid on the principal plus the interest that was previously earned. This goes on in perpetuity and has an exponential compounding effect.
For example, an account with $100 that earns 5% interest compounded annually will total $105 after the first year. So, the $100 principal plus the $5 in interest paid. If the $5 in interest is re-invested along with the original $100 and again earned 5%, the total at the end of year 2 would be $110.25. An so it goes year after year.
How does compound interest work?
The mathematical formula for calculating compound interest is:
A = P (1 +r/n) (nt)
Exciting I know.
In this equation you are solving for A. In our prior example A is the future value including interest or $105 at the end of year 1.
P is the Principal or the initial deposit. $100 in our example
r is the annual interest. 5% in our example
n is the number of times per year interest is compounded. once in our example
t is the number of years the money is invested.
Now that we got the math lesson over with, lets get down to what actually goes in to this.
The principal is what you put in to the account. Your initial deposit. The interest rate will determine how much your initial deposit will grow over a specified period of time. The higher the interest rate, the more money for you. Yay!
The frequency of interest payments will impact your account total at the end of the year as well. In our prior example of $100 at 5% annually you ended the year with $105. But take the same investment and interest and compound monthly and you would have $105.12. Twelve cents may not seem like a large difference but consider if you left that account sitting idle for 40 years, the difference between monthly compounding vs annually is $32.
On a one million dollar principle over 40 years the difference would be $300,000. It is important you understand the tremendous impact even a slight variation can have over time.
Time IS Money
Time is the final piece of the puzzle as you may have already deduced. Compound interest will not make you rich over night. It will not even make you rich in a year. But given enough time there is no doubt that you will become rich. It is not a matter of if, only when. You just need to be relentless in your pursuit and have patience.
A good starting point for you to begin making simple estimates is the 7/10 rule. The 7/10 rule based on the mathematical fact that it will take your money 7 years to double if you consistently earn 10% interest compounded annually. Furthermore, it will take 10 years for your money to double if you can consistently earn 7% compounded annually.
To demonstrate, below is a chart showing the year by year growth of a $1000 principal over 10 years at 7% and 10% interest rates compounded annually.
| Year | 7% Per Year | 10 % Per Year |
| 1 | $1070 | $1100 |
| 2 | $1145 | $1210 |
| 3 | $1225 | #1331 |
| 4 | $1311 | $1464 |
| 5 | $1402 | $1610 |
| 6 | $1500 | $1771 |
| 7 | $1606 | $1950 |
| 8 | $1718 | $2144 |
| 9 | $1838 | $2358 |
| 10 | $1970 | $2594 |
As you can see in the chart, the growth accelerates over time. If you carry out the 10% chart to 50 years you end up with a total of $117,391 from your original investment of $1000. That is a gain of 11,640%.
Don’t like my numbers? Try this compound interest calculator from investor.gov for yourself.
How compound interest can make you rich
As you can see, capitalizing on compound interest can allow you to achieve gains that would otherwise seem impossible. You simply need to allow it to work for you. There are only 2 requirements for you to get rich using compound interest.
Step 1: Start Early
Step 2: Be Patient
That’s it. It will take time for the returns to start rolling in, and the velocity will increase with time. This is why it is important to start early. The earlier you start, the more time you have before you need to begin taking withdrawals and the larger your account will grow.
Therefore, you will also need to be patient. The system works if you let it. You can not lose patience and begin to make withdrawals or you will destroy the compounding effect.
If you are really looking to make this interesting you can add deposits at regular frequencies. In the chart below we will look at an initial $1000 investment as we did earlier only now we will add $100 per month. Again, the chart shows your total at the end of each year for a 7% annual interest and 10%.
| Year | 7% per year | 10% per year |
| 1 | $2308 | $2350 |
| 2 | $3707 | $3844 |
| 3 | $5205 | $5482 |
| 4 | $6808 | $7284 |
| 5 | $8522 | $9266 |
| 10 | $19,072 | $22,580 |
| 20 | $54,623 | $78,552 |
| 30 | $124,558 | $223,734 |
| 40 | $261,128 | $600,294 |
| 50 | $532,752 | $1,576,995 |
Now that you have seen what is possible, the next logical question is…
How can I start earning compound interest today?
There are many ways you can invest your money to start earning interest today. Choosing which option or mix of options will be different for everyone and will depend on your level of risk tolerance. Typically, the higher the interest rate you can earn, the higher the risk to your investments. Low risk investments will typically offer very little in terms of return on investment,
Here are a few ways you can start earning compound interest today.
Savings Account
Probably the simplest way to earn interest. Almost everyone has had one since they were a child. You deposit your money in the bank and in return they offer you interest. There is virtually zero risk to your money with a savings account and therefore the returns are almost zero.
US Savings Bonds
US savings bonds are issued by the US treasury. They are backed by the full faith of the US Government. They come in 2 types.
- EE Series pay monthly interest at a fixed rate and mature after 20 years. You can cash these in after 1 year but will not receive full value.
If you need to cash in EE Bonds before 5 years you will pay a penalty.
EE Series Bonds are subject to federal income tax.
- Series I Bonds pay a variable rate and the rate will be the current rates at the time of purchase plus recently calculated rate of inflation. The inflation rate will be re-calculated once every 6 months. This is considered a safe investment and is a good hedge against inflation but offer low yields.
Dividend Stocks
Dividend stocks are stocks that pay dividends at regular intervals throughout the year. It can be monthly, quarterly or annually. Most brokers will offer a Dividend Re-Investment Program (DRIP) which will automatically re-invest your dividends back into the stock. If left to be re-invested, these dividends will compound over time in the same manner as other types of interest.
Growth Stocks/Index Funds/Mutual Funds
Any stocks, mutual funds, or index funds in the stock market have the ability to earn compound interest. This is one of the riskier options so there is the potential for larger gains. However, the potential for loss is also present especially if you are picking individual stocks. Historical studies show that the average return of the stock market of the past 100 years is in the 7% range the theory is that if you stick to diversified funds you should be able to see pretty steady and secure returns.
Certificates of Deposit (CD’s)
A CD is an investment option offered by most banks and credit unions that typically pay higher interest rates than savings accounts. In return you agree to keep your money in the CD for a specified amount of time. The bank pays more because they can now use your money for longer term investments without the risk of you withdrawing the funds.
When opening a CD you will chooses the length of the term your funds will be locked up. Typically, the longer the term, the higher the return on investment. Banks will often offer an early withdrawal but it will come with a penalty which will cut into your earned interest.
As your CD matures (the term isup) you will need to decide what to do. Most banks will automatically roll over the CD with the same terms.
Money Market Account
A money market account is a savings account that may come with a higher interest rate than a traditional savings account. Money market accounts typically require large minimum deposits which is the reason they can offer higher rates than a typical savings account.
These are just a few example of ways in which you can start earning compound interest today. If you want to become rich you will need to get your money working for you and the best way to do this is to figure out which investments work best for you and go for it.
Good Luck and Happy Investing
Earl