Compound interest possesses a truly magical power that defies conventional expectations. If you save and invest consistently over a long period of time, you can transform meager sums into a rather substantial fortune. The results of compounding can seem almost unbelievable.
The Consumer Financial Protection Bureau (CFPB) defines compound interest quite simply: “When you earn interest on both the money you save and the interest you earn.”
Yes, compound interest is a concept in finance that involves earning interest or returns not only on the initial amount of money you have but also on the interest that accumulates over time. But, these descriptions don’t really capture the magic of compound interest. Reinvestment of the interest or returns you gain on your money allows for exponential growth as the interest continues to compound. The exponential growth is the magic.
Exponential growth is a pattern of growth in which a quantity or value increases at an ever-accelerating rate over time, resulting in a significant overall expansion.
In simple terms, Compound interest is like a snowball you roll in wet snow and it keeps getting bigger. Your money grows not just from the initial investment but also from the interest generated by that investment.
So, let’s say you invest $1,000 this year and earn a 6% return. Without doing anything else, next year, you will have $1,060. And, again, without doing anything else, the following year you’ll earn $63.60. While an extra $3.60 on the initial extra $60 doesn’t seem like a lot. You didn’t have to do anything to earn that money. And that magical money will just keep growing over time and it will really add up.
The longer you keep your money invested and allow the interest to compound, the more significant the growth becomes. Compound interest has the power to amplify your savings or investments over time, making it a valuable tool for building wealth and achieving financial goals.
The longer the duration, the more magical compounding becomes, as even modest contributions can yield remarkable results. Compounding interest weaves its enchantment, enabling financial goals to materialize beyond imagination, proving that small, consistent actions can unlock the gates to extraordinary wealth and abundance.
The secret to having your money invested for a long period of time? Start saving and investing as early as possible!
An Example of How the Earlier You Start Saving, Investing, and Compounding, the Better
Here’s an example to illustrate why starting early with compounding can be beneficial:
Let’s consider two individuals, Ben and Chris. Assuming both individuals will retire at age 65, here is how their savings would add up:
- Ben starts saving at age 25 and contributes $1,250 per month for 40 years (480 months).
- Total contributions over 40 years: $600,000 ($1,250 x 480).
- Assuming an average annual return of 7%, the total value of the retirement account at age 65 would be approximately $4,365,018.
- Chris starts saving at age 45. Let’s assume that her salary is double that of Ben’s, and she is able to contribute 20% of $150,000 or $2,500 per month for 20 years (240 months).
- This is double the monthly savings contribution to what Ben saved over half the number of years.
- Total contributions over 20 years: $600,000 ($2,500 x 240).
- This is equal to what Ben saved.
- Assuming an average annual return of 6%, the total value of the retirement account at age 65 would be approximately $1,142,362.
- While probably perfectly adequate for retirement, this sum is more than $3 million less than what Ben has at age 65.
Both Ben and Chris contributed the same amount to savings, but Ben, who started saving 20 years earlier, ends up with a significantly higher retirement savings balance (more than $3 million) despite the higher monthly contributions made by Chris. This emphasizes the importance of starting early and allowing investments more time to grow.
NOTE: While the examples above demonstrate the value of starting early, it is important to note that even if someone starts saving later in their 30s or 40s, consistent and substantial contributions can still lead to significant retirement savings by retirement age.
Chris ended up with more than $1 million!
In the examples above, you’ll notice that both Ben and Chris saved and invested consistently. While this steadfast devotion to saving is not magical like compounding, it is a key to long term wealth creation.
Imagine compounding interest as a magical seed that, when planted in fertile soil, grows into an extraordinary tree.
At first, the seed represents your initial investment or savings. As time passes, this seed sprouts and begins to bear fruits – the interest earned. However, instead of plucking these fruits, you carefully collect them and replant them around the base of the tree.
With each passing season, these fruits grow into new trees, each one producing an abundance of fruits of its own. As the cycle repeats, the forest of trees expands exponentially, generating a bountiful harvest. Compounding interest works in a similar way, where the interest earned becomes the seeds that grow into new investments, creating a flourishing forest of wealth. Just as a small seed can transform into a majestic forest, compounding interest has the magical power to transform small investments into substantial financial success over time.
It may help you to understand the somewhat abstract concept of compound interest if you are able to see it in the context of your own financial situation.
The NewRetirement Planner enables you to model your savings contributions and interest rate or returns and see the future value of the account. Model different scenarios with different savings rates or rates of return or change those values over time to really learn how to grow wealth.
This powerful tool helps you keep track of your current and future net worth and find your path to the future you want.