By Elizabeth Carlassare.
Today’s topic is compound interest.
Albert Einstein is often quoted as having said something to the effect that compound interest is the greatest wonder of the universe. It’s an urban legend, but it packs some punch!
In today’s episode, I want to tell you about the magic of compound interest.
We hear about compound interest all the time, but what is it really? Simply put, compound interest is interest you earn on your interest. And it’s a really important concept to understand, because compound interest has the power to turn a modest investment into a lot of money over time. So listen up.
Compound Interest Versus Simple Interest
There are two different types of interest: compound interest and simple interest.
With compound interest, the interest you earn goes to work for you and earns more interest. You earn interest on both your principal and your accrued interest. With simple interest, on the other hand, this isn’t the case: the interest you earn is not reinvested to earn more interest.
Take, for example, two people we’ll call Compound Connor and Simple Simon. Compound Connor invests $1,000 earning interest at 10% compounded monthly. Simple Simon also invests $1,000, but earns simple interest at 10%.
After one year, Simple Simon’s $1,000 has grown to $1,100, while Compound Connor’s $1,000 has grown to $1,104.71 OK, so what’s the big deal? That $4.71 difference is almost insignificant.
Well, here’s the thing: over time, the effect of compound interest is phenomenal – actually, it’s exponential. Fast forward 30 years. Compound Connor’s $1,000 investment has grown to almost $20,000, whereas Simple Simon’s has grown to only $4,000. Now, that’s a big difference.
The Power of Time
Compound interest is the reason it really pays to start investing early. People who start investing at a young age have a big advantage. Time, combined with the power of compound interest, is really amazing, which leads me to a second example.
Imagine two brothers: We’ll them call Early Eddie and Late Lino. If Early Eddie invests $10,000 at age 20, earns 10% interest compounded annually, and then stops and doesn’t invest anything more, he’ll have almost $729,000 when he reaches age 65. You heard that right. His one-time $10,000 investment grows into almost $729,000, which is more than 72 times his original investment!
Late Lino, on the other hand, waits until age 50 to begin investing for retirement. He invests the same $10,000, earns 10% interest compounded annually, and also doesn’t add anything more. Fifteen years later at age 65, Late Lino’s $10,000 has grown to $41,772.
But what happens if instead Late Lino tries to make up for lost time by investing $10,000 a year beginning at age 50? At age 65 after investing a total of $150,000, Late Lino will have about $391,000 – far less than the $729,000 Eddie has to show for his one-time $10,000 investment at age 20.
The tip to take away from this example is this: Invest as early as you can! If you’re young, you have the enormous advantage of having more time for compound interest to work its magic. And, if you’re not so young, there’s no time like the present to get started. So start saving and investing now.
The Power of a Higher Rate of Return
Compound interest really shows its power at higher interest rates. So here’s one last example with corny names. Let’s take the example of a different set of brothers: twins named Low Louis and High Henry. Low Louis invests $1,000 at 10% interest compounded annually. At the same time High Henry invests $1,000 but earns 20% compounded annually. Since High Henry’s interest rate is twice as much, you might think that he would earn twice as much. But that’s not the case at all. He actually earns much, much more. After 30 years, Low Louis’ $1,000 investment has grown to $17,449 while High Henry’s $1,000 investment has grown to more than $237,000. You heard that right: $237,000. More than 13 times more from an interest rate that was twice as much!
The tip here is that earning a higher rate of return makes a remarkable difference over time. You definitely don’t want to store your hard-earned money under the mattress! Invest as early as you can and invest your money so that it earns a healthy rate of return.
Here's a compound interest calculator that lets you see how your money will grow over time at different rates of compound interest.
Lastly, make sure that when you invest you leave enough money aside for your emergency fund.
Cha-ching! That's all for now, courtesy of Money Girl, your guide to a richer life.
As always, everyone’s situation is different, so be sure to consult a tax or financial advisor before making important financial decisions. This podcast is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice.
Send your questions or comments to............or call them in to my voicemail line: 877-6-RICHER. And, I’d really appreciate it if you took a moment to post a review at iTunes.
Thanks for listening!
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