The Magic of Compound Interest

The magic of compound interest, oh the MAGIC. Before I get overly excited let’s talk about the differences between simple and compound interest.

Most people are familiar with simple interest. Let’s say you deposit $1,000 into an account earning 2% in simple interest. With a 2% interest rate, you’ll earn $20 at the end of the year. Keep the principal amount and interest earned in the account. At the end of year two, you’ll earn another $20 on the principal amount.

Compound interest allows you to earn interest not only on the money you’ve saved but also on any interest you may have earned. If you deposit $1,000 in an account, at the end of year one you would earn $20. Keep the principal, the original $1,000, and the $20 earned in interest, in the account and at the end of year two you earn interest on $1,020, not just on the $1,000. Simply, your interest earns interest. That’s the power of compound interest. It’s your money making you money.

Let’s look at some examples:

Example 1: Imagine if you save or invest $150 a month for 60 months and at a rate of return of 8% a year, at the end of 5 years you’ll have a total of $11,404. ($9,000 contributions + $2,404 growth)

Not bad, but let’s face it, we are in it to win it. Compound interest works best the longer it has to grow.

Example 2: Parents open an investment account for their newborn baby. They commit to saving $2,000 every year in an account that averages 8% growth annually. After five years they stop making contributions. The account sits for the next 60 years. Not a penny more is contributed besides the initial $10,000. If the account is left untouched, at the age of 65 the account would balloon to $1,283,130.

Example 3: Sally Saver graduates from college at age 21 and enters the workforce. She manages to save $200 a month for the next several years. At age 30, she stops contributing to her retirement. By now, her account has increased in value.

Since Sally left her retirement account untouched, take a look at the growth of her $10,000 contributions:

Sally now has over a million dollars! See I told you it was magic.  Okay, not really magic, but compound interest over time is wonderful.

Example 4: Paul Procrastinator also graduates from the same college as Sally. He enters the workforce and is so glad to upgrade his lifestyle. He doesn’t save much money and doesn’t invest his retirement account. He postpones contributing to retirement until 40. He begins to contribute $400 a month to his retirement account. His investment also has an average growth rate of 10%. By the age of 65 he’s contributed $120,000 to his retirement account. His account at age 65 is worth $519,272. ($120,000 contributions + $399,272 growth)

Whatever you save earns interest, not just on what you put in, but also on the money it picks up along the way. That is the power of compound interest. The longer you invest the less money you need to save, but the more it will grow. Plug-in your own numbers here and see how compound interest might work for you. For those of you who would rather calculate using the compound interest formula, you’re welcome:

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