It is rumored that Albert Einstein once quipped that the most powerful force in the universe is the principle of compounding. In investing and finance, this force manifests itself through the concept of compounding returns. In simple terms, compound interest means that you begin to earn interest on the interest you receive, which multiplies your money at an accelerated rate.
For example, if you have $500 and earn 10% interest per year, you will have $550 after one year. Then, if you earn 10% interest the next year on that $550, you end up with $605 by the end of year two. The process continues until, eventually, your original $500 may be eclipsed by the amount of interest you gained.
This is one way many top investors find success in building their wealth. But it's not just for the top investors—you can take advantage of compound interest through savings accounts and investment portfolios. Learn how to do that below.
What Determines How Much Compound Interest You Can Earn?
There are three main factors that can influence the rate at which your money compounds:
- The rate of return, or the profit, on your investment: For example, if you are investing in dividend-paying stocks, this would be your total profit from capital gains and dividends. If you were putting money in a savings account, this would be the annual percentage yield (APY).
- Time: The more time you give your money to build upon itself, the more it compounds. For example, all things equal, your money would grow more over a 10-year period than it would over a five-year period.
- The tax rate, and when you have to pay taxes on your interest: You will end up with far more money if you don’t have to pay taxes at all, or at least not until the end of the compounding period rather than at the end of each year. This is why tax-deferred accounts, such as the traditional IRA, Roth IRA, 401(k), and SEP-IRA, are so important to consider.
Keep in mind that with traditional IRAs and 401(k) plans, you will owe taxes at your normal income tax rates at the time when you take money out of the account. A Roth IRA, and even a Roth 401(k), will grow and you won't owe taxes when you withdraw the money in retirement.
Compound Interest and the Time Value of Money
The foundation behind compounding interest is the concept of the time value of money, which states that the value of money changes, depending upon when it is received. Having $100 today is preferable to receiving it a few years from now because you can invest it to generate dividends and interest income. Compounding allows that money to grow. If you waited two years to receive that $100, you'd miss out on two years of opportunity to earn compound interest. This is known as opportunity cost.
Opportunity cost is the loss of possible gains if an action is not chosen. In this case, the opportunity cost is equal to the amount of money you do not get in interest if you don't invest in that money.
In our earlier example, if you don't invest the $500 in an account with 10% annual interest, you'll lose the opportunity to earn $50 or more per year in interest. In 10 years, your $500 could be $1,296.87. But if you don't invest it, it'll still be $500 10 years later.
You can calculate how much you could earn on your money through the power of compound interest with a compound interest calculator.
When you understand the time value of money, you'll see that compounding and patience are the ingredients for building wealth.
Here's another example: Let's say you are 30 years old and want to have $1 million by the time you retire at age 65. You can afford to save $800 per month in an account with an 8% annual return on your investment. Will you be able to reach your goal? Using a compound interest calculator, you can see that you'd be able to turn that $800 per month into $1 million after 29 years—six years earlier than you plan on retiring.
Compound Interest Results Over Time
Another way to understand the power of compound interest is to put values into a compound interest table that shows you just how much your wealth can multiply over time.
Imagine you're an investor who sets aside a lump sum of $10,000. Take a look at the table below to see the influence of time and different rates of return on this investment. Over time, saving money is not the only key to a large fortune; compound interest plays a big part.
|Compound Interest Chart|
For instance, a 20-year-old who invests $10,000 today and parks it in Treasury bills, earning 4% per year, on average, for the next 50 years, will have $71,067, if the purchases were made through a tax-free account such as a Roth IRA. If they had invested in stocks and real estate, earning a 12% average annual rate of return over the same time, they would end up with $2,890,022. Adding asset classes with higher returns would result in over 40 times more money, thanks to the power of compounding.
How Compound Interest Could Impact Teens and Their Savings
Your teenage years are a good time to start saving money for the future. Because you have time for that money to grow before you may need it to buy a house or retire, you can benefit greatly from compound interest. One easy way to start earning compound interest is to open a high-yield savings account and contribute a set amount to it every month. Over time. your money could grow a lot and allow you to build your wealth. While you may only be able to earn a small amount of interest in a savings account, the compound interest could add up over time. For example, if you contributed $50 per month to a high-yield savings account and earned 0.5% interest per year, you could have over $12,000 after 20 years.
Once you've got the savings part down, you could try your hand at investing to potentially benefit even more compound interest. For example, let's say you opened an investment account with the help of an adult (you usually need to be 18 years or older to invest). If you contributed $100 per month to the investment account for 40 years, and earned a 10% annual rate of return on investment each year, your money could grow to be more than $530,000.
A Higher Rate of Return Often Comes With More Risk
You may want to do whatever it takes to earn a higher rate of return on your savings or investments, but that can also be dangerous because higher rates usually bring higher risk. No matter how successful you are along the way, you'll always want to avoid the possibility of losing more than a budgeted amount of the money you invest.
To lower your risk, consider all your investment possibilities. You could start with a high-yield savings account, earning a decent amount of interest on that money year over year. There are also certificates of deposits (CDs) and money market accounts that offer you the chance to earn interest on your money. Stocks, bonds, exchange-traded funds (ETFs), index funds, and mutual funds are also investments to explore. Adding a variety of investments to your portfolio can help you diversify that risk and build your wealth through the power of compound interest.
Frequently Asked Questions (FAQs)
What is compound interest?
Compound interest is when you earn interest on top of the interest you've already earned on the principal amount of money. For example, if you started with $100 and earned 10% interest in one year, you'd have $110 after one year. If you earned 10% on that $110 over the course of another year, you'd end up with $121. Compound interest is the money you earned in that second year because the interest applied to your original principal and the interest you earned in the first year.
How do you calculate compound interest?
Compound interest can be easily calculated with the help of a compound interest calculator. But if you want to do it manually, you'll need to follow this formula: Multiple your annual interest rate by your principal starting value. Add the result to the principal starting value. This is your new principal value. Repeat the process. For example, 10% x $100 = $10, $10 + $100 = $110, $110 is your new principal balance.
How can you get compound interest?
You can get compound interest by opening a financial account that offers some sort of annual rate of return. For example, you could open a savings account with an APY of 0.5% and contribute money to it every month to get compound interest and grow your money.
What is the difference between simple and compound interest?
Simple interest is calculated only on the principal balance, while compound interest is calculated on both the principal and any interest that you've already earned. So if you had $100 and earned 10% on that $100 principal balance every year, you'd be earning simple interest. If the 10% interest applied to the new balance every year ($100 in year one, $110 in year two, etc,) you'd be earning compound interest.
U.S. Securities and Exchange Commission. "Investor Bulletin: World Investor Week."
IRS. "401(k) Plan Overview."
IRS. "Roth Comparison Chart."
Investor.gov. "Compound Interest Calculator."
Investor.gov. "What Is Compound Interest?"
U.S. Office of Financial Readiness. "Understanding Interest and How To Calculate It."