When asked what mankind’s greatest invention was, Albert Einstein replied: “Compound Interest”. He has also been quoted as saying that compound interest is the “eighth wonder of the world.”
In this article, I want to help explain the real power of compound interest, how you can take advantage of it, and what it could mean for your financial situation. But before we get there, let’s first understand what compound interest is.
What is compound interest?
There is no better way to explain compound interest than Benjamin Franklin’s quote: “money makes money. And the money that money makes, makes money.” Feel free to read that a few times over and really soak it in, and then let’s hop into an example.
Imagine you start with $100, and you have that money invested in an index fund full of different stocks. On average, the total world stock index returns 7% per year. So, at the end of the first year, your original $100 worth of index funds is now valued at $107. This is where the magic happens – in the second year you gain another 7%, but instead of gaining 7% of $100 (which would be another $7) you gain 7% of $107, which comes out to an additional $7.49.
It might seem like a minimal gain initially, BUT the real power of compound interest starts to shine over time. In this same example, after 30 years of compounding, your initial $100 is worth a whopping $761 compared to just $310 if your money was not compounding. That is more than doubling your end result with the power of compound interest! Add a couple of zeros to this calculation, and you can quickly see why this is the eighth wonder of the world.
Here is a nice graphic from the Visual Capitalist (with a couple more zeros) to help you visualize this example to highlight the power of compound interest.
As you can see, over time the interest, and the interest earned on the interest, really starts to add up.
I think it is worth explaining that when people say compound “interest”, it doesn’t always mean that you are earning “interest”. In this last example, you purchased an index fund that appreciated in value over time – you didn’t actually gain any “interest” on your index fund, but as it appreciated by 7% each year, that growth of 7% continued on the new, higher-value each year. Now let’s explore just how much of a difference compounding can make in your financial situation.
The power of compound excitement.
The true power of compound interest shows itself over time. To help understand the relationship between time and compounding, let’s look at another example from the Visual Capitalist.
In this example, you have Jessica on the left and Newman on the right. Jessica starts saving ten years before Newman, at the age of 25. On the other hand, Newman waits until he is 35 to begin investing. BUT he invests twice as much as Jessica every year from when he starts to when they both turn 65. Any bets on who has more money when it is all said and done?
If you guessed Jessica, then you are CORRECT!
Despite having saved only half the amount that Newman did, Jessica still ends up with a larger investment balance simply because she got started ten years earlier and put compound interest to work on her behalf!
I hope this is starting to help connect the dots.
The earlier you start saving and investing, the more powerful compound interest becomes.
So all that being said, what can you do to take advantage of the power of compound interest?
How to harness the power of compound interest?
This is as simple as it gets: start saving and investing TODAY. The sooner you start, the easier it is. I think one of the biggest areas that people fail with personal finance is thinking that they have to have everything perfectly figured out before they get started. This means they end up waiting a lot longer than they should to start investing. My challenge to you is to figure out what amount you could set aside right now to get started! Realize that the best time to start investing was yesterday, and the second-best time is today. By getting started now, you can harness the incredible power of compound interest and put your money to work.
Think about this: you have to save nearly twice as much money to get to the same end result for every ten years that you wait to start investing. So put another way, the sooner you start, the less you need to save to reach the same level of wealth.
To continue to drive home the point, here is another graphic from the Visual Capitalist. This shows how much money you would need to invest to end up with 1 million dollars at the end of each time period. The results are staggering. At the top, you can see that if you want to be a millionaire in 15 years, you will need to invest $33k PER YEAR. But what if you start when you are 20 years old and want to be a millionaire by 65? That gives you 45 years to let the power of compounding work on your behalf, and you would only need to invest $3k per year!
Now that you understand what compound interest is, the true power, and how to harness it. Let’s talk a bit about what it could mean for your financial situation.
What compound interest can do for your financial situation.
Armed with the knowledge of compounding, you start to see why it can be so powerful to start saving and investing while you are young. Referencing the graphic above, if you have 50 years to save and invest, you can become a millionaire by only investing $107,500. Contrast that with someone who delays saving for retirement and only has 20 years to save; they would need to invest $419,000 to reach that same $1 million mark. Plain and simple, start early, and the money will do the work for you. Start later, and you will need to do a lot of the work to get there.
Putting it all together.
To sum it all up, compound interest is the interest you earn on the interest that you have earned. It is a multiplying force that will propel you to financial independence and put your money to work on your behalf. By understanding the relationship between compound interest and time, you can see the real value in getting started young with your savings and investments. By delaying saving and investing, you lose some of the power of compounding. This will result in you having to put forth more of the effort rather than letting your money work on your behalf. Remember, the best time to start saving was yesterday, and the second-best time is today. Do not delay, and do not hesitate to share this with any young people in your life that are wondering if they should start investing now or if they should wait.