Compound Interest: The 8^th World Wonder

With compound interest, you reinvest all of the interest earned throughout the 20 years, annually. Following this example with the formula used to calculate compound interest, we can see that the future value of the investment/loan, including interest, will be approximately $265,330.00. This is seen by the example below.

A = P(1 + r/n)^(nt)

• P = $100,000
• r = 0.05 (5% annual interest)
• n = 1 (since it's compounded annually)
• t = 20 years

A = 100,000(1 + 0.05/1)^(1*20) ≈ 265,330.00

After 20 years, with compound interest, the value grows to approximately $265,330.00.

This can be compared to a portfolio earning simple interest by the calculation below.

Using the simple interest formula:

A = P(1 + rt)

• P = $100,000
• r = 0.05 (5% annual interest)
• t = 20 years

Plugging these values into the formula:

A = 100,000(1 + 0.05 * 20) = 200,000

After 20 years, with simple interest, the value grows to $200,000.

With compound interest, the value grows to $265,330.00 while it only grows to $200,000.00 with simple interest. As a result, compound interest earned $65,330.00 more, depicting the accelerated effect compound interest can have on your wealth growth. Compound interest allows your wealth to work for you, driving potential growth on your initial investment.

If you have heard the concept of “Time is Money”, you understand that the longer you leave your money invested, the more dramatic the growth in earnings you can potentially experience. This is true with the concept of compound interest. Accounts with compound interest can allow you to earn money at a steeper rate, the longer you leave it invested.

This is exemplified by the different effects compound interest has on a deposit over the course of 5, 10, and 20 years. Let’s continue with the example above where we have an initial investment of $100,000 with an annual interest rate of 5%, compounded annually.

Using the compound interest formula:
A = P(1 + r/n)^(nt)

where

• P = $100,000
• r = 0.05 (5% annual interest)
• n = 1 (compounded annually)
• t = 5 years

A = 100,000(1 + 0.05/1)^(1*5) ≈ 127,628

After 5 years, the investment grows to $127,628.

Using the same formula for 10 years:

A = 100,000(1 + 0.05/1)^(1*10)
A ≈ 162,889

After 10 years, the investment grows to $162,889.

For 20 years

A = 100,000(1 + 0.05/1)^(1*20) ≈ 265,330

After 20 years, the investment grows to $265,330.

The longer you leave your money invested in an account that offers compounded interest, the more substantial the potential growth is. Over 5 years, the deposit grows by $27,628, over 10 years it grows by $62,889, and over 20 years, it grows by $165,330. The key takeaway from this is that time plays an important role in compounding wealth. The longer you allow your deposit to compound, the more dramatic the effect can be. Even small amounts of money have substantial potential growth if invested for a long time.

While interest accrues continuously over a period of time, it is only compounded at certain intervals. Interest can be compounded annually, semi-annually, monthly, etc. The shorter the amount of time between compounding periods, the higher potential for growth your investment has. This is because the sooner you can redeposit your interest earned, the sooner it can earn interest on itself. This is the power of compounding. It is important to pay attention to the frequency schedule of compound interest to identify what is the best strategy for your financial goals.

Compound interest can apply to a variety of financial vehicles, helping investors grow their wealth over time. Some common examples include:

1. Savings Accounts: Many high-yield savings accounts offer compound interest, allowing your deposited funds to earn interest on both the principal and the interest already accrued.
2. Certificates of Deposit (CDs): With a CD, you lock in your money for a specific period (e.g., 1, 3, or 5 years). The interest you earn is compounded periodically.
3. Bonds: Some bonds, particularly those that are reinvested, may pay interest that compounds. This can be seen with certain types of municipal or corporate bonds that allow reinvestment of interest payments.
4. Retirement Accounts (IRAs, 401(k)s): Investment accounts designed for retirement, such as IRAs and 401(k)s, allow compound interest to work over long periods. Contributions grow tax-deferred, and interest compounds on both the original contributions and any accumulated earnings.
5. Mutual Funds and ETFs: These investment vehicles pool money from many investors to invest in stocks, bonds, or other assets. Earnings (dividends, interest, capital gains) are often reinvested, allowing compound interest to increase the value of your investment over time.
6. Index Funds: Like mutual funds, index funds benefit from compound interest when dividends or interest are reinvested. These funds track a specific market index and can provide long-term growth as they benefit from market trends and the compounding effect.
7. Peer-to-Peer Lending: In some peer-to-peer lending platforms, interest is paid and compounded on loans made to borrowers, allowing lenders to earn compound interest on their initial investment.
8. Stocks: While stocks themselves don’t pay compound interest, reinvesting dividends from stocks can create the same compounding effect, helping investors build wealth over time.

While compound interest is a powerful tool for growing wealth, it can work against you when applied to debt. When interest on loans or credit card balances compounds, it can create the opposite snowball effect: quickly spiraling out of control. The longer the debt is left unpaid, the more interest accumulates on the principal and the interest that’s been added, leading to much higher overall repayment amounts. For example, credit cards often charge high-interest rates, and if payments are only made on the minimum balance, the interest can compound rapidly, making it difficult to pay off the debt. This makes it especially important to manage debt carefully and avoid carrying high-interest balances for extended periods of time.

Another consideration to take with compound interest is tax implications. With earnings often come taxes. This means the potentially exponential earnings with compound interest could introduce different tax implications. Check if the interest you are earning is in a pre-tax or post-tax account.

Compound interest is a powerful tool that can reward long-term investors, offering potential exponential growth for their money over time. It offers a snowball effect, where the returns can continuously build upon themselves, working to make it easier to accumulate wealth passively. By committing to long-term investments, individuals can harness the power of compounding in hopes to gradually increase their wealth with minimal effort. When applying compound interest to your finances, it is important to consider how often it compounds, reinvestment of earnings, what types of accounts it is invested in, debt and loans, and any tax implications.

If you would like to learn more about compound interest and the implications it can have on your finances, you can contact us to schedule an introductory call.