This is what Albert Einstein had to stay about 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
So what’s so wonderful about it? What do we need to understand?
Here’s an example of compound interest working it magic.
You make an initial investment of $20,000. Over 20 years, you contribute $500 each month. At the of 20 years, you have $284,669.80
You contribute a total of $130,000 (green line) but you end up with $284,669.80 (blue line). Pretty good right?
Your profit turns out to be $155,000. That’s like getting a house for free!
This chart clearly explains that compound interest is good and truly a wonder as Albert Einstein describes it.
what is compound interest?
This is the Merriam-Webster definition of compound interest.
Does this definition make sense to you?
If it doesn’t, don’t worry, most definitions don’t make sense until you hear it used in a sentence or see an example.
Think of compound interest as exponential vs linear growth.
Here’s the difference between exponential and linear growth.
Both charts start at $10,000. All that was invested was $10,000. After 20 years, one ends with $46,609.57 the other with $26,000.
Which chart would you rather have your money in?
So how does money grow exponentially? It grows exponentially because interest is calculated on a number that continues to grow year after year. The higher the number, the more interest.
|Year||Future Value||8% Compound Interest|
|Year||Future Value||8% Regular Interest|
In the tables above, you see side by side compound interest vs regular interest.
In the compound interest table, the amount in the compound interest column continues to increase year after year. That’s because interest is calculated on the previous year’s balance. The higher the number, the more interest. And the number (or balance) always grows.
You can also think of it as a snowball coming down a hill. The further it goes down, the more snow it accumulates and the bigger it gets.
In the regular interest table, the amount in the regular interest column stays the same. It stays the same because interest is always calculated on the initial investment of $10,000. Interest will always be $10,000×0.08%.
If you can’t define it or explain it, don’t worry, you’re never going to be quizzed on the definition.
At the end of the day, all you have to understand is this; compound interest helps you make thousands and thousands of dollars for free.
The secret is waiting and just seeing your money go up exponentially year after year.
How To Calculate Compound Interest
Use the compound interest calculator from investor.gov to calculate compound interest. It’s really easy to follow and you get your results in seconds.
When you calculate compound interest, you’ll have to enter an estimated interest rate. Most people reference the average annual return of the S&P 500 market index. The S&P 500 return has been about 10% over the last 30 years.
I usually enter an estimated interest rate of 8%. Market returns fluctuate (go up and down) and are never consistent so to be on the “safe side”. I enter an 8% interest rate.
If you’re feeling ambitious, the compound interest formula is below.
- A = final amount
- P = initial principal balance
- r = interest rate
- n = number of times interest applied per time period
- t = number of time periods elapsed
important to understand
The money you contribute must stay in your account.
Think of it as money you won’t see again for the next 15, 20, or 30 years.
If you start taking money out, you’ll lose thousands and thousands of dollars. You have to let compound interest do its magic. The exponential growth will take some time but when you reach it, it goes up really fast.
Compound Interest Examples
Waiting 30 years vs 20 years.
The longer you wait the better, much better.
Here’s an example of waiting 30 years vs 20 years.
In both scenarios, you start with and only invest $50,000. The difference? Time. After 30 years, your total return is $503,132.84. After 20 years, your total return is $233,047.86.
A ten-year difference equals $270,085.
I don’t want this example to discourage you from investing and think “you’re to late too start”. It’s never too late to start investing. Would you rather have nothing or more? Even if it’s a little more?
I had the fear that I had missed out on compound interest because I didn’t start investing in my early 20s. I started investing in the stock market when I was 30. If I wait 30 years, I’ll be 60, right in line with retirement so I know I’ll be just fine.
Contributing $250 vs $500.
The more you contribute, the better. Although making no contributions will also make you money, see example #1 above.
So what’s the difference between a $300/month vs a $500/month contribution?
Total = $842,982.48
Total = $1,182,832.11
The difference is $339,849.63.
Guys, that’s a lot of money. I’m sure you can find a way to contribute $500 instead of $250.
The more you invest the better!
Making only one initial investment and only having to wait.
Let’s say you invest $100,000 and make no contributions over 30 years. How much will you have at the end of 30 years?
You’ll have $1,006,265.69.
For doing nothing but waiting, that sounds really good to me!
How To Earn Compound Interest
After understanding what compound interest is and seeing for yourself how much it can impact your investment. I’m sure immediately going to ask, How can I earn compound interest?
You’ll need to open an investment account. You can either meet with a Registered Investment Advisor (RIA) or open an account yourself.
One way to mimic the return of the S&P 500 and get the same return is to invest in an index fund that mirrors the S&P 500. You have a lot of options, just do your research. If you want to learn about index funds, read, Index Funds For Beginners.
If you’re not comfortable with investing on your own. I highly recommend meeting with an RIA.
My goal in writing this is to help you understand how powerful compound interest is.
You don’t have to do anything except make monthly contributions. You saw the difference a $250/month contribution can make. It can cost you $340,000! For reference, see example #2 above.
Let time work in your favor and start ASAP. The longer you wait, the better!
In summary, think of compound interest as a snowball going down Mount Everest. The snowball at the top starts small but as it goes down it gets bigger and bigger. The longer the slope, the bigger the snowball.
The longer you wait, the bigger your account gets.