“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein
As the name Young + Scrappy probably implies, I work with a lot of young people, many of whom have the overwhelming sense that they’ll never be able to retire. It’s not that they don’t want to–it’s just that everyone seems to assume it’s not a viable option for them.
To these folks, I gently remind them that saving for retirement isn’t about stocking away cash: it’s about investing. Sure, you need to save your current income in order to have something in the future, but you’ve also got a powerful force on your side: compound interest.
What is Interest?
The primary characteristic that separates saving from investing is the fact that investing is risky. However, investors are compensated for taking risk by also getting the opportunity to make more money. We call this the risk-reward (or risk-return) tradeoff. The more risky an investment is, the higher potential payoff, in theory.
This is why your FDIC-insured savings account has a near-zero interest rate, and even the high yield ones don’t typically keep up with inflation. On the other hand, the stock market has years with 40% returns, as well as years with -40% returns, consistent with both higher risk and higher return.
For sake of argument, we’ll call this rate of return on your investment “interest.” We’ll also call the money you put towards an investment the “principal.” In other words, you invest a certain amount of principal, and then the money you make on that principal is the interest.
The concept of interest is fairly straightforward, but in order to understand where we get the “compound” part of compound interest, I want to walk through three scenarios with you.
Scenario #1: Saving Up Cash
Let’s imagine at first that you’re saving up money in cash. You decide you can save $500/year for a period of five years. The typical interest rate is so negligible that we’ll call it zero.
Since the interest rate is zero, what you have at the end of five years is simply what you put into the account, so long as you don’t spend any of it. This makes for a fairly straightforward calculation: $500 multiplied by 5 years is $2500. The table below breaks down these numbers:
Example 1: Saving up Cash
Scenario #2: Investing with 10% Simple Interest
Now let’s imagine that you are still committed to putting away $500/year for five years, but this time you have the opportunity to invest the money at a 10% rate of return.
You get to earn this 10% on whatever money you’ve put into the account, which is known as simple interest. For the first year, you get 10% of $500, which is $50. By the second year, you’ve put in a total of $1000 ($500+$500), which means you get $100 in interest. By the third year, you’ve put in a total of $1500, so you earn $150 on that money, and so on.
Once again, the chart below breaks down the principal, interest, and the total. After five years of 10% simple interest, you’ve made $750 in interest, bringing your $2500 in principal up to an account balance of $3250.
Example 2: Investing with 10% Simple Interest
We call this type of return “simple interest” because you are only making money on what you’ve contributed to the account. Not bad, but you could definitely do better.
Scenario #3: Investing with 10% Compound Interest
In the last scenario, the interest calculation was only applied to the principal you put in, but with compound interest, you make money not just on your principle, but also on all previous interest that has been paid to you. As a result, the money accumulates faster with compound interest than it does with simple interest.
Consider the chart below. At the end of year one, you’ve made the same $50 in interest. However, during year two, you now get to earn 10% not just on the $1000 of contributions, but rather on the $1050 total account balance. This gives you interest of $105, versus only $100 with simple interest. This may not seem like a lot, but by year 5 you’re making $305.26 in compound interest, versus $250 under the simple interest scenario.
At the end of year five, you’ve contributed $2500 and made $871.81 in interest, for a total account balance of $3357.81.
Example 3: Investing with 10% Compound Interest
Compound Interest Over Time
The basic examples above illustrate that compound interest produces a higher account balance than no interest or simple interest, given the same annual principal, interest rate, and time horizon.
What the examples above *don’t* show is how powerful compound interest is over periods longer than five years. In fact, the longer you can invest the money, the more amplified the effects of compound interest are compared to simple interest or a savings account.
To illustrate the power of compound interest over time, let’s imagine a 35 year old is saving for retirement, which will take place at age 65. They decide to invest $500 per year for the 30 years until retirement, at the same rate of 10% (which is close to the long-term average return of the S&P 500 since its inception in 1928).
You can see that over a longer time period, compound interest is even more powerful: it’s incredible that $15,500 could potentially turn into over $100,000 with the right investments and a whole lot of patience.
These numbers are purely hypothetical, since they don’t take into account fees or issues associated with the timing of when you put money in. However, they drive home a very important point: if you want to retire, you’ve got to have compound interest on your side.
Compound interest is a simple trick, but so powerful that even Einstein called it the eighth wonder of the world. For this reason, we recommend you:
- Take advantage of compound interest. If you’ve got a long time horizon such as retirement, it’s better to invest the money rather than letting it languish in a savings account. Investing your money allows you to harness the power of compound interest, so that it grows faster.
- Invest early. The longer you can invest your money, the more powerful compound interest becomes. We recommend getting started as soon as possible, so your money has more time to grow and compound.
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