The Magic of Compound Interest

Financial Literacy The Magic of Compound Interest

Personal finance and investing gurus are fond of an old Chinese proverb: “The best time to plant a tree was 20 years ago. The second best time is now.” Chances are you’ve heard it before.

It’s a profound quote, and trees are a great metaphor for growing your investment portfolio. If you water the tree daily – and have patience – you can expect to reap the rewards in due time. Whether you start investing in college or after you turn 40, the important thing is planting the seed.

The problem is, this proverb actually undersells the importance of starting as soon as possible from an investing perspective.

While a tree grows to maturity at a sustained rate and only reaches a certain height, investments actually grow larger the earlier you start. If investments are trees, then the seed you planted today may grow as tall as a mighty redwood, while the one you plant in 20 years becomes a pine. In other words, the growth potential of your portfolio is directly tied to the amount of time you give it to grow.

This is thanks to something called compound interest, where the interest your account accrues is compounded on itself. Here’s everything you need to know about compound interest – how it can help you, how it can hurt you and how to maximize its benefits.

What is Compound Interest?

There are two ways to accrue interest: simple and compound. Simple interest is when you earn interest only on the principal. So if you have $1,000 invested at 5% interest, you’ll earn $50 every year.

Compound interest is earned on the principal and the interest in your account. Let’s say you have $5,000 in a retirement account, earning 7% interest each year. The first year you earn $350 in interest, which brings your total to $5,350. The following year, interest is calculated based on that $5,350 total, not the original $5,000. You earn $374 in interest and now have a total of $5,724.

Even if you never deposit anything but the original $5,000, you’ll have $38,061.28 in 30 years. That’s a $33,061.28 profit.

Compound interest rewards people who invest over long periods of time, not necessarily those who can afford to invest the most. It’s specifically helpful for young people who start investing early.

A 25-year-old who invests $200 a month with 7% interest will have $226,705.89 in 30 years. If they wait 10 years to start investing, they’ll have to more than double their savings rate to reach the same total.

When Compound Interest Hurts You

Compound interest is your best friend when you’re investing or saving for a long-term goal, but it’s your worst enemy if you have debt that’s not being paid off.

Here’s an example: A borrower with $30,000 in student loans defers their loans for a year while they look for a job. During that year, interest continues to accrue on those loans. Once they’re ready to resume paying, they discover their $30,000 balance has grown to $45,000 because of compound interest.

To slow down the negative effects of compound interest, you should pay off your debt as quickly as possible. You can also refinance your loans to a lower interest rate. If you have credit card debt, transfer to a card with 0% APR to avoid interest while you pay off the balance.

How to Maximize Compound Interest

Some banks only calculate interest on a monthly basis while others do it every day. More frequent compounding is better when you’re trying to maximize interest, so find out how frequently your bank calculates interest. You might have to call or poke around the fine print to determine their compounding schedule.

Next, find the highest interest rates possible while also minimizing risk. If you have a savings account with $10,000, choose a high-yield savings account. Aim for 2% interest or higher. A $5,000 savings account with 2% interest will be worth $7,459.04 in 20 years, but only worth $5,204.05 in a savings account with .2% interest. Using an investment calculator can give you a better idea of how interest will impact your return.

If you’re saving for retirement, invest in low-fee index funds. Fees of 1% or more will drag down your profit and cut into your compound interest. Index funds will follow the market’s course and provide a solid rate of return. Avoid picking individual stocks, as their volatility can be problematic.

Compound interest works best if you start saving as soon as possible, even if it’s just $25 a month. A 22-year-old who saves $25 a month at 7% interest for five years will have $1,795.80. When she gets a raise after those five years and can afford to put away $100 a month, she’ll have $294,213.07 when she retires at age 67. If she hadn’t started investing until after her raise, she’d only have $264,689.70.

Even though she only contributed $1,500 during those first five years, her portfolio is worth nearly $30,000 more. For most people, that’s enough to retire a full year earlier, and all it cost her was a monthly contribution of $25. Even someone earning an entry-level salary can afford that.

The same principle applies for debt. Even if you defer your student loans, keep making payments on them as much as you can afford to. Taking time off will only delay your debt payoff and increase how much you pay in interest.

Always compare rates before taking out a loan and get at least three quotes. Each percentage point matters when you’re borrowing money, especially for long-term debt like a mortgage. You can also limit compound interest by borrowing money for as little time as possible.

A 30-year $200,000 mortgage at 4.85% interest will cost $379,940 in total. A borrower who takes out the same loan for 15 years will only pay $269,910. That’s a difference of $110,000, which is more than half the total mortgage principal.


Comments (9) Leave your comment

  1. The mortgage example was very profound. I always thought taking out a 30 year loan and making extra payments was best, but now I see the benefit of a 15 year mortgage instead. Great read!

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