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Whether through student loans, investments, or your savings account, you’ve surely been hearing about the importance of managing interest. There are several different types of interest, but for anyone looking to make the most out of their investments and improve their financial situation, knowing the basics of compound interest is a must.
So, what is compounding? It’s essentially earning interest on your interest. And it is some serious money magic. Sounds a little weird, right? Let’s break it down.
What Is Compounding?
Earning simple interest on your account means that the interest is earned and calculated based on the principal amount alone. So, you’re seeing returns only for the initial amount of money you put into the investment, which is great! But it could be better.
Here’s where the magic of compounding comes in.
Earning compound interest on your account ensures that you see returns not only on your initial principal amount, but also for the interest it accumulates over time.
Depending on how frequently the interest is compounded, your account’s balance grows at a much faster rate than it would when accumulating only simple interest.
Let’s look at an example.
Say you deposited $100,000 dollars into your savings account. If that account earns 5% simple annual interest, it would accumulate $50,000 in interest across 10 years.
Now get ready to have your mind blown.
Depositing an identical initial investment into a savings account that earns 5% compound annual interest instead would accumulate just under $63,000 in interest over the same amount of time.
That extra $13,000 in your pocket will go a long way when building up your long-term wealth and saving for retirement. It’s more money, after all.
As mentioned above, the rate of growth for your balance in a bank account that accumulates compound interest differs depending on how frequently the interest is compounded, or more simply, how many compounding periods it has. A good rule of thumb to remember is that the more compounding periods there are, the more compound interest your balance will earn.
There are about 5 different options for compounding periods. In order from least to most interest earned, they are annually, semi-annually, quarterly, monthly, and daily. If you deposited $100,000 into an account with 5% compound interest, here is the amount of interest each different compounding period would accumulate over the course of a decade:
- Annually: Compounded once per year = $62,889.46.
- Semi-annually: Compounded twice per year = $63,861.64.
- Quarterly: Compounded 4 times per year = $64,361.95.
- Monthly: Compounded 12 times per year = $64,700.95.
- Daily: Compounded 365 times per year = $64,866.48.
As you can see, compounding interest more frequently results in higher and higher average annual return on your initial investment, so you can maximize your investment account by aiming for more frequent compounding periods, such as quarterly or monthly.
That’s literally the only difference.
The Rule of 72
The Rule of 72 is a handy way to calculate how long an investment will take to double in value. It only works for annual compounding, but the calculation is pretty straightforward.
Simply divide 72 by your annual interest rate, and ta-da! You have an estimate of when your investment will double.
For example, if your investment has an 8% annual rate of return, you can expect it to double in 9 years while a 6% annual rate of return will cause it to double in 12 years.
The Importance of Investing Early
Now you know how compounding works, but how do you go about making the most of it?
The answer is: start investing early.
Using compound interest to your advantage will hugely increase your investment returns, but it’s going to take time for the wealth to accumulate.
Investing in your 20’s increases the likelihood your account will grow exponentially and you’ll reach your financial goals, especially compared to someone who began investing later in life.
Even if your annual compounded rates are lower than those of a friend who started investing much later than you, compound interest works to grow your wealth over time, leaving you with an excellent retirement investment portfolio in the future.
Take Warren Buffett for example. As of 2021, his net worth is estimated just below $104 billion.
Gaining a sum like this is no small feat, and Buffett earned his fortune over a lifetime of investing. In fact, starting early was the key to Buffett’s success! Even though his annual compounded rate is 22%, smaller than investors like Jim Simons, who boasts a 66% annual rate, he has been investing his money since he was just 10 years old. Throughout his lifetime, he has been consistently taking advantage of compound interest to maximize his long-term wealth.
Having consistent good returns like this over a long period is much more valuable than seeking out extremely high one-time returns.
If you want to become a successful income investor and meet your investment objectives, you need to understand the power of compounding. Even if you don’t end up with a $104 billion fortune, using compound interest to your advantage now will set you up for a comfortable and relaxing retirement in the years to come.
In fact, when you’re off living the retirement of your dreams, I guarantee you’ll be thanking your past self for figuring out how the hell compound interest works!