Compound interest refers to a method of continually reapplying interest to a principal that is growing over time. This calculation of interest is present on virtually all credit card and loan payments where a debt grows with each unpaid billing cycle. However, compound interest can also work to your advantage when it's applied to your savings or retirement investments.
This method is interchangeably known as compounding interest, compound return, and compound annual growth rate, and it's a powerful financial force when allowed to accumulate over a long period of time.
Time Is Your Friend
Compound interest puts your money to work and grows larger as it feeds on itself. The Rule of 72 dictates that in order to obtain a rough estimate of how many years it will take for your initial investment to duplicate itself, you should divide that initial investment by 72.
For example, $1 invested at an annual fixed interest rate of 10% would take 7.2 years ((72/10) = 7.2) to grow to $2.
Investing pioneer John C. Bogle was an American investor, business magnate, philanthropist, and founder of The Vanguard Group who died in 2019. He is credited with creating the first index fund.
Bogle cautioned that you're unlikely to get rich quick, especially if you're relying on compound interest and argued that a 7.5% annual return for stocks and a 3.5% annual return for bonds is reasonable in the long-run. He wrote in his book, The Clash of the Cultures: Investment vs. Speculation:
"Time is your friend, impulse is your enemy. Take advantage of compound interest and don’t be captivated by the siren song of the market. That only seduces you into buying after stocks have soared and selling after they plunge."
Bogle's basic philosophy is that the earlier you start investing or saving, the less risk you will need to tolerate, and the more money you will stand to make over time. The magic of compound interest is in the time an investment is allowed to grow.
Compound Interest Examples
Imagine that you put $100 into a retirement investment account. It earns interest at a rate of 10% per year. At the end of a year, you have $110.
Year Two: You start year two with $110 in your investment account—$100 from the principal and $10 from the earned interest. You keep the full $110—both your principal and the earned interest—vested in an interest bearing account throughout the year. By the end of year two, your investment has grown by another $11, for a total of $121.
In year one, you earned $10 in interest, because the only money that you had was the principal. But in year two, you earned $11 in interest, because you had the principal plus the first year's interest. In other words, that extra $1 represents the interest that compounded on top of your interest.
Year Three: You start year three with $121 in your investment account. You earn 10%, or $12.10. At the end of the year, you now have $133.10. Notice how your 10% payout has grown—from $10 the first year, to $11 the second year, to $12.10 the third year. It is because interest is compounding on top of previous interest.
Year Four: In the fourth year, your 10% payment will be $13.31 (which is 10% of $133.10), which means you'll end the year with $146.41. At this point, you've earned $46 on your original investment of $100. Not bad.
Choosing to Not Reinvest
In year one, you get a 10% return. You keep the principal, the original $100, invested, but you spend the extra $10. At the start of year two, you still only have $100 invested.
You do this every year, keeping the original $100 invested, but removing the extra $10. By the end of year 4, you've made only $40, not $46.41, because you didn't let the interest compound.
Imagine letting compound interest work with $10,000. At a 10% compounding interest rate, you'll earn $4,600 on your original investment by the end of the fourth year. Better yet, imagine doing this with $100,000. At a 10% compounding rate, you'd earn $46,000.
Having considered the example above, keep in mind that most investments don't provide consistent 10% returns to investors, but this doesn't change the nature of how compound interest generates wealth.
Whatever amount of money you can afford to put away in a savings account—whether you're receiving returns of 10%, 7%, or lower—the longer you let interest compound on itself, the more dramatic your gains will be.
It's never to late...or too early to start saving!