How Does Compound Interest Work?
Compound interest is a double-edged sword: It can either work for you or against you. So make sure you get it on your side!
Contrary to what its name might lead you to believe, the subject of “interest” isn’t all that interesting. But that doesn’t mean it’s not important—far from it. Gaining a basic grasp of how various types of interest rates work is a crucial first step in becoming financially literate.
But to make matters more complicated, there are several different kinds of interest out there. We recently wrote about how variable interest rates work, and today’s article will instead focus on compound interest. Because the more you know, the better you’ll borrow—and save.
What is compound interest?
Whether you are borrowing money or investing it, there are two main types of interest: simple interest and compound interest. If you’re an investor, compound interest is your friend. But if you’re a borrower, it’s a foe.
“Compound interest is the amount paid on the initial principal and the accumulated interest on the money you’ve either invested or borrowed,” explained Nathan Wade, Managing Editor for WealthFit Investing. “The sum of money grows faster compared to simple interest.
“This is because you’re earning returns on the money you invest and you also receive returns on those returns at the end of each compounding period,” he continued. “The interest is calculated on the initial principal which does include accumulated interest of previous periods of a deposit or loan. Essentially, compound interest allows you to earn interest on your interest.”
“Now if you are a borrower, compound interest hurts you rather than helps you,” said finance expert Ron Auerbach. “Compound interest is calculated in the exact same when you’re borrowing money: The only difference is that instead of your getting that money (interest), you now have to pay it. So with compound interest on a loan, you’ll owe more than if your loan was a simple interest one.”
How does compounding interest work?
In order to explain how compound interest works, it helps to start with an explanation of simple interest.
“Simple interest only gives you interest on your original amount,” said Auerbach. “For example, you deposit $100 into an account that earns five percent simple interest per year. At the end of one year, your account will grow to $105.”
“And simple interest is calculated by taking your original amount multiplied by the annual rate of interest. In my example, that would be your $100 deposit times five percent, which is 0.05. Doing this multiplication gives you five dollars.
“Now with simple interest, it’s a fixed rate. That means each year, your interest amount will be the same. So how much would you earn in simple interest in year two? Another five dollars. So by the end of the second year, you’d have $110. In other words, you only get interest on your original amount! “
“But what if we were dealing with compound interest?” he continued. “In this case, you’d be getting interest on top of your original amount, plus interest on top of any previous interest you’ve received. So using my example from above, at the end of year one, you’d have the same $105 as you did with simple interest.
“However, in year two, you’d earn interest on the original $100 and interest on the five dollars interest from year one. So you’re getting interest on the $105 at the end of year one, which would be $105 x 0.05 = $5.25. At the end of year two, you’d have a total of $110.25.”
The Rule of 72.
According to Steven Briggs of Briggs Financial, The “Rule of 72” in important shorthand you should know to help you understand the power of compounding interest.
“What this rule tells you is that if you know the interest rate or rate of return, you can divide 72 by that interest rate to get the number of years it takes for your money to double,” he said.
Briggs also offered the following example:
“If you have had your money in an S&P 500 index fund, the rate of return has been give or take about nine percent. 72 divided by nine is eight, meaning that about every eight years, the value of your account doubled. Over a 32 year career, the first dollars you put in would have doubled 4 times, meaning that $1,000 invested back then has earned you $16,000 today.”
“This also applies in a negative direction with debt interest rates,” He continued. If your credit card, for example, has an 18% interest rate, we can take 72 divided by 18 and find that our debt will double in approximately four years.
“Wait, you may be saying, you’re telling me that my credit card interest rates could be double or more that of average investment market performance? Yes, which is why before clients of mine work on anything involving investing, we get rid of the guaranteed high-interest debt first.”
“I cannot predict how the market will perform,” said Briggs, “but an 18% interest is guaranteed to charge that against your balance. That’s a lot of money being given away for the privilege of Visa and Mastercard and American Express letting you borrow it. I hate it, and you should hate it too, hate it enough to want to get rid of it as soon as humanly possible.
Make compound interest work for you.
If you are saving money for retirement, you need to take advantage of compounding interest by putting your money into retirement accounts or other investment vehicles. If you just leave it in a savings account, you almost certainly won’t have enough to retire on.
Similarly, if you’re letting your financial future get bogged down in high-interest credit card debt, you are essentially throwing your money down the drain. Whatever you do, you need to make sure that compound interest is working for you, not against you.
“The main component to consider is that most of us are not taking advantage of compounding interest in a meaning and positive way,” urged Josh Littauer, a financial adviser with Wealth Wave. “For example, if your money is in a checking account the interest rate is typically between .25% and .5%, at these rates it would take between 144 and 288 years for your money to double. Not very good right?”
That’s why Littauer encourages everyone he works with to find ways to minimize the use of interest against them and find ways to starting getting interest on their side: “There are plenty of investment vehicles that will give you 6-12% return annually, but in many cases we need to get out of debt first in order to maximize our ability to get a return.
“I often get the argument that ‘I don’t make enough money to invest,’” he continued. “There is an example of a man who was a UPS driver his whole career starting at 22, during which he committed to investing 20% every year. His income was less that 20,000 annually, and yet when he retired he was worth seven million dollars! He took advantage of compound interest early and it paid off in a huge way!”
“The moral of the story, compound interest will make or break you. Einstein calls it the eighth wonder of the world, but if that eighth wonder is working against you it’s hard to combat,” concluded Littauer, who added that you should “make sure interest is working in your best interest.”
Ron Auerbach holds degrees in finance, accounting, economics, and human resources. As a highly-experienced educator, he’s taught subjects from A to Z. This includes personal and corporate finance, economics, accounting, and business math. Mr. Auerbach has also worked in many industries. This includes banking and financial services, retail, hospitality, IT, education, and sales And he is the author of the job search book, Think Like an Interviewer: Your Job Hunting Guide to Success.
Steven Briggs is the owner of Briggs Financial, a fee-only financial planning and investment management firm located in Round Lake Beach, IL. He primarily works with his clients online, serving households from coast to coast. Steven is also the host of “Money is Personal,” a weekly personal finance podcast available on iTunes. Additionally, he volunteers as a board member of the Northwest Housing Partnership, a nonprofit organization that facilitates affordable housing for families throughout Northwest Chicago.
Josh Littauer (@josh_littauer) is a financial adviser with Wealth Wave, and an associate of World Financial Group. Josh focuses on bringing education to a financially illiterate society while combining habits, mindset, and perspective from his professional Crossfit career. Our nation and culture are struggling both physically and financially, Josh aspires to change both of those for you and your family. In his spare time, Josh enjoys reading, writing, having a good beer, and exercising.
Nathan Wade is a licensed attorney for the State of Hawaii and the U.S. District Court of Hawaii. He holds a law degree with a focus in business and has extensive experience in entrepreneurship and international business. He is also a Managing Editor for WealthFit Investing, a financial education blog dedicated to curating advice on investing, entrepreneurship and money.
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