“Compound interest is the eighth wonder of the world.
He who understands it, earns it. He who doesn’t, pays it.”
Picture this: You save $3,000 per year for the next 30 years. How much money will you have?
The answer is $90,000, right?
That’s true—if you simply put the money away in a safe in the closet. And if you do, you’ll most likely end up losing out on hundreds of thousands of dollars. If you had saved that money in a mutual fund that earned an average return of 8% per year, you would have $339,850 after 30 years.
Yes, you read that right. You would almost quadruple your money.
When you leverage the power of compound interest, you can turn your savings into much, much more. As Einstein said, compound interest is a true wonder. In short, it lets you use your money to make you more money.
Want to learn more? Let’s go over all you need to know about compound interest and your savings.
Simple interest—interest that doesn’t compound—works by adding a certain percentage of your principal (the amount of money you start with) to your savings over a certain period of time. In this case, you earn the same amount of money in interest on your savings each year (or month, or any other set timeframe).
Compound interest, on the other hand, occurs when interest is added to your principal, then the interest rate is applied to your new, larger principal. While interest can be compounded at any frequency, annual rates are the most common.
Let’s look at an example. Say you have $20,000 to save. With a simple interest rate of 2%, you’d end up with $24,000 after ten years. But if you decided to save that money in a Certificate of Deposit that earns 2% annual compound interest, you’d end up with $24,379.89 after the same period of time.
Why do you earn almost $400 more with compound interest? That’s because when calculating compound interest, you include all the accumulated interest from previous periods into the principal. In this sense, compound interest is actually interest on top of interest! The longer you let that interest accrue, the more you’ll earn on it.
Remember the saying that “a penny saved is a penny earned.” While that’s true, a penny compounded turns into many more pennies.
Note: If you’re interested in the math behind it, the amount of money you’ll end up with thanks to compound interest is calculated using a mathematical formula. This formula considers the principal, the yearly interest rate, and how long your money will accrue interest (in years).
As time goes on, the effect of compound interest becomes greater. To illustrate this, consider the following example of two friends: Lily and Henry.
Lily begins saving for retirement at age 25. She saves $5,000 per year into a Roth IRA, which is an individual retirement account that allows for tax-free withdrawals once you reach retirement age. Lily saves exactly $5,000 per year for 40 years until she’s 65. She earns an average annual return of 7%.
By the time Lily retires at 65, her Roth IRA has the following balance:
Lily is a millionaire. And she got there by saving a total of $200,000 over 40 years. Compound interest made that possible.
Now, let’s discuss Henry:
Henry begins saving into a Roth IRA at age 35. He also saves $5,000 per year. Like Lily, Henry retires at age 65. And his Roth IRA earns an average return of 7%. However, he has only saved for 30 years.
By the time Henry retires at 65, his Roth IRA has the following balance:
$506,127
Henry is not a millionaire. Though compound interest did enable him to turn $150,000 in savings into $506,127, he began saving ten years later than Lily. And because of that, Lily’s Roth IRA has more than double the amount of cash his Roth IRA does.
Do you see the value of time when it comes to compound interest and your savings?
To see how much your savings could grow over time, you can use a compound interest calculator like this one from NerdWallet. Playing around with investment calculators can show you just how powerful compound interest is and help reinforce the importance of putting your savings to work through high-interest savings accounts, retirement accounts, mutual funds, and other investments.
Becoming financially secure relies on you using compound interest to your advantage through smart savings and investment strategies. It also involves avoiding the bad side of compound interest (which usually occurs with credit card debt). While you want to earn compound interest, you definitely want to avoid paying compound interest.
As Experian notes, many credit card providers compound interest daily, allowing interest fees to accumulate at a high rate. This is why it can be so hard to get out of credit card debt. Unless you pay off the balance in full each month, you’ll pay compound interest on your debt. And considering how high credit card interest rates are, you can end up paying a lot in interest.
Other types of loans, such as mortgages and federal student loans, generally don’t charge daily compounding interest. As long as your monthly payment covers the interest fees, you won’t pay compound interest. If your payments don’t cover all the interest fees, however, your debt will grow.
There are many ways to build compound interest into your long-term savings strategy. You could:
Save money in a high-interest savings or checking account. Some banks offer more than 4% annual percentage yield (APY), according to a list compiled by MagnifyMoney (as of July 2020).
Save the money in a bank that offers daily compounding. According to The Balance, banks that offer daily compounding include Ally Bank and Marcus by Goldman Sachs. With daily compounding, your savings will earn more interest than if compounding occurred monthly, quarterly, or yearly.
Save money in a money market fund or CD. This is a pretty safe way to earn 1–2% on your savings. If you don’t need to access this cash, you can watch it compound over time.
Invest the money into a retirement account. 401Ks and IRAs come with tax advantages. Additionally, most are invested in mutual funds and bonds that have solid track records. While there is always risk involved with investing, history shows that investing in the stock market has been an effective way to build wealth.
Invest the money into income investments. Dividend stocks, real estate investment trusts (REITs), municipal bonds, and other income-focused investments can generate yields of as high as 10% (and sometimes higher). But keep in mind the higher the potential yield, the higher the risk probably is. Choose a fund with a good track record, and the power of compound interest should become clear as time passes.
As Warren Buffet attests, part of the reason he’s become so wealthy is because of compound interest. You should take note of that and make compound interest the focus of how you manage your savings—no more putting money away in the sock drawer!
By leveraging the power of compound interest, you ensure that you stay ahead of inflation and build the best possible nest egg. Just remember the more time you let compound interest work, the more benefits you’ll reap.