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The Power of Compound Interest

Published 10/14/07 (Modified 3/8/11)
By MoneyBlueBook

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

  1. 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!
  2. 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.
  3. Keep adding to your investment over time - Early and often is the key.
  4. 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.

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8 Responses to “The Power of Compound Interest” 

  1. Wanda says:

    Hi Raymond, thanks for visiting my site. :) I also have a Flavia machine at work, but it's still hard to skip Starbucks for that.

  2. Mrs. Micah says:

    Makes me glad to be young!

  3. Raymond says:

    Mrs. Micah, I hope you are taking advantage of your youth and compound interest potential. Start saving!

  4. Marshall Middle says:

    Excellent articles, keep up the good work.

  5. CatherineL says:

    Hi Raymond. Did I read that right - your annual return is 40%? You must be a really smart investor.

    Compound interest has always fascinated me.

  6. Raymond says:

    Hi Catherine,
    Far from it. I just chose to focus my investments in developing and emerging markets like China and Southeast Asia, excluding Japan. I think investors really need to rethink their conservative investment strategies and allocate more portfolio space for growth markets. I'm probably an extreme case, but my portfolio is comprised of nearly 100% emerging market funds.

    There are so many opportunities. I recently missed out on a stock I was tracking for several years. In the last few months, due to a China deal it just signed, the stock has soared nearly 400%...obviously I'm bummed that I missed the boat :(

  7. albert starcher says:

    hi raymond, my name is albert, i live in houston and im an 18 year old from cypress creek highschool about to graduate in a week. Around january of next year im suppose to recieve $10,000 from my brothers trust. my question to you (becasue you appear to know a thing or two about investing,) is how should i invest this money im either going to invest some or all not sure i plan to attend community college then goto SFA to finish out college then i plan to goto med school im aspiring to become an anesthesiologist if i choose to specialize other wise just a general physician. Also you can tell im very interested in learning how to invest and how to manipulate the stock market in my favor. If you know a thing or two, i would love to hear from you. thank you Raymond.

  8. Raymond says:

    Albert,

    Congratulations on your affirmative decision to start investing at such an early age. Many of us often wish we could go back in time and start investing as early as you. However, since you are still 18 years old and have indicated that you are rather new to stock market investing, I would urge you to exercise great caution as your tread into this new adventure. I invested recklessly when I was in college and got badly burned. Now, I know better and have learned from my past failures. It's best not to trade short term swings but rather to invest in solid long term positions focused on value.

    My advice is to start out by opening a Roth IRA retirement account. Your earnings will accrue a steady rate of return tax free and you are free to invest in any stock or mutual funds of your choice. To open a Roth or even a traditional IRA account, you will have to select a broker. I recommend going with the more established and well known ones like TradeKing, TD Ameritrade, Sharebuilder, or Etrade.

    Once you have opened a Roth IRA account, I would recommend putting the money into an index or mutual fund, preferably one that tracks a broad index like an exchange traded fund (ETF). A few I'd recommend are the "SPY" and the "VTI" - both ETF funds track broad indexes. The SPY Index tracks the S&P 500 and the VTI Total Market fund tracks a huge basket of stocks and is one of the broadest index for the U.S. equity market. By taking these initial baby steps, you will gradually become more familiar with investing terminology and generate confidence in your long term positions.

    Good luck in your future pursuit of a career in medicine!

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