The Power of Compound Interest
Published 10/14/07 (Modified 3/8/11)
The mightiest monetary force in all of the investment world is not the Federal Reserve. It is the power of the compound interest. If I could offer only a single piece of financial advice to anyone, I would encourage the individual to understand how compound interest works and why its effects are so dramatic over time. Even ole Albert Einstein supposedly called it the "greatest mathematical discovery of all time", and deservedly so.
Very few people become rich or financially secure through wages alone due to the realities of the trading hours for dollars concept, but by taking advantage of the miracle of compound interest, you can have a much better shot at achieving your financial goals.
The way compound interest works is quite straight forward. When you invest money, you earn a certain percentage as interest for the first year. In the second year you earn interest on the original principle and the interest accumulated during the first year. In the third year you will earn interest on the original principle as well as interest on all the previously accumulated interest. The more time that passes the greater the interest that accumulates.
The best time to invest was yesterday, but the second best time is now. Don't delay! The sooner in time you start investing the greater the benefit you'll reap through compounded interest.
Hypothetical Example To Demonstrate the Power of Compound Interest
To illustrate, let's compare two people - Bill and Hillary. Bill invests $2000 for 6 years straight in a savings account earning a fixed 12% interest rate. Let's not worry about taxes for now. After the 6th year, Bill stops investing and lets his account go on autopilot as compound interest continues to accrue.
At the same time, let's assume Hillary does nothing for the first 6 years. But after the 6th year, Hillary starts to put $2000 into a 12% savings account and continues to add this same amount every year and doesn't stop.
Since Hillary had a 6 year late start, how long will Hillary need to continue putting money into her account after the initial missed 6 years before her balance will eventually be greater than Bill's. The answer is 37 years! At that time, Hillary's total account balance will be $1,235,557, compared to Bill's $1,235,339.
Bill's total out-of-pocket investment of $2,000 for 6 years was only $12,000. Hillary on the other hand had to contribute $2,000 for 37 years for a total of $74,000 to ultimately beat out Bill's account balance. Bill contributed less money but because he started much earlier, he gained the early compound interest advantage over Hillary, even though Hillary contributed substantially more overall.
There's also an interest infographic on the power of compound interest rates.
Critical Compound Interest Rules To Remember That Will Maximize Your Investment
- Start as early as possible - If you have money that is not at the very least sitting in a savings account earning interest, what are you waiting for? Get some interest accruing now!
- Get the highest interest rate or return on your investment possible. My current approximate investment portfolio annual rate of return is about 40%. But mine is likely riskier than is appropriate for most people. If you want stable and predictable returns, then at the very least put your money in a savings or money market account earning 5% APY.
- Keep adding to your investment over time - Early and often is the key.
- The more time that has passed the greater your investment will have grown through compound interest. Your investment horizon should not be a matter of a few years. You should think in greater terms, like 10 or 20 years.