Certified Financial Planner®
Guess who once said, “compound interest is the eighth wonder of the world”? The answer is at the end of this post. The quote goes on to say “he who understands it, earns it…. he who doesn’t, pays it”. I agree on both fronts. Compound interest is extremely powerful and just being aware of its existence is what allows many people to begin to think long-term. Thinking long-term is an extremely important perspective to have because it allows us to delay short-term gratification.
What is Compound Interest
Compound interest is the ability for assets to not only generate interest on your original investment but the ability for the interest generated to then be able to create its own interest. In a short amount of time, it may not look like much, but over a series of years, investments can grow substantially depending on the growth rate.
The Rule of 72
There is a quick shortcut you can use to estimate the time it will take an investment to double. It is called the Rule of 72. Just divide the number 72 by the annual interest rate you expect to find the answer.
Even at a low rate of 3%, an investment can double after 24 years.
72 Divided By 3 = 24
If interest is earned at an annual rate of 7%, it will double after 10 years and 4 months.
72 Divided By 7= 10.285
Starting from Zero
One of the biggest challenges that most people face is not having the initial savings in the first place. Don’t let that hold you back though because practically everyone starts from ZERO and nowadays many start in negative territory due to student loan debt (that is a story for another day).
There isn’t a quick trick to calculate the value of investing consistently over time, but the compounding impact is still being applied. Again it will start out small, to the point where you may not think it is meaningful, but after many years of being disciplined your monthly savings will be less than the interest you have earned.
Then if you wait a little bit longer, it may grow to the point where it generates more income than you do in a year. Think about that. Your investments will someday outearn you.
Just in case you think I’m hallucinating here is a case study:
Ms. Saver Earns $100,000 a year. And saves 10% of her income which is $10,000 a year. If she manages to earn a 6%* annual return then her investment growth will be greater than her $10,000 a year savings by year 12. It will take until year 41 for her investments to be able to generate $100,000 in growth. In year 41 the investment balance would be almost 1.75 Million!
Of that $1.75 Million Ms. Saver would have only saved $410,000 and the rest would have been growing through compounding.
As you can see from this example, compound interest is ridiculously powerful and allows your assets the power to outwork you if given enough time. The earlier you can start the better. If you are late to the game compound interest still works, you just may have to save at a larger percentage of your income to make up for the lost time.
ANSWER: Albert Einstein
*Growth rates are purely for illustrative purposes. Savers and investors must navigate all of their options when choosing the optimal location for their assets by weighing the risk versus expected return over long-term investment horizons*
**Information provided is for general educational purposes only and is not to be considered advice. It is recommended that you conduct additional research or consult a professional before implementing any information obtained from this article.**