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what is compound interest and how does it work

What is compound interest?

What is compound interest, and how does it work?

Simply put, compound interest is when you earn interest on your interest. It’s when your money makes money. Compound interest allows your money to grow more quickly—and even exponentially—over time.

Compound interest is one of my favorite topics related to personal finance because compound interest is so powerful. And it was actually a discussion about compound interest in a college class that actually had nothing to do with money or finance in general that first sparked my interest in personal finance—an interest that has now become a 14-year-plus passion and hobby (and now, with this blog, side hustle). The instructor actually showed a chart very similar in concept to the one you’ll see below, and I think it was that chart, more than anything else, that got me hooked. And I’m hoping that chart and this article will be an impetus for change for many of you (actually, all of you :)), as well.

But remember that compound interest is also a double-edged sword. When compound interest is working for you, such as in long-term investing in good stock mutual funds, it can help you earn great returns on your money. But when it is working against you, such as with high-interest credit cards, it makes it more difficult to get out of debt and to win with your money because all of the interest that accumulates. As Albert Einstein reportedly said: “Those that understand interest earn it, while those who don’t pay it.”

How does compound interest work?

It might be easiest to illustrate how compound interest works with an example. So let’s say you have $1,000 in a retirement account. And that year you earn 10 percent on your money, or $100. So the next year you would start with $1,100. And the next year, you earn the same 10 percent. So this time you earn $110 on the $1,100, so by the end of the next year you had $1,210. So you invested only $1,000, but after two years you have $1,210, and you never had to add anything to that money to increase it.

Now, let’s say you keep that $1,000 in your investment account for 40 years, an average working lifetime. And you never add anything to it. After 40 years of an average annual rate of return of 10 percent, you would have $45,259! And what if you earned instead a 12 percent average annual rate of return, which is very reasonable over the long-term if you invest in good stock mutual funds? Your balance would be $93,051! Isn’t that awesome?! That amazing increase is because of the exponential growth that occurs when your interest earns interest.

And now just for fun, let’s double the initial investment to $2,000. If you again received an annual average rate of return of 12 percent, after 40 years, from just investing that $2,000, you would have $186,101. Isn’t it fun to geek out on this stuff a little? 😀 Do you have a youth or young adult in your life that you could share this information with? A middle or high schooler, college student, or fairly recent college graduate? It seriously can change their life (and everyone else’s—including yours)!

Why is compound interest so important?

Compound interest is so important because of the very powerful effect it can have on your financial situation over time. If you have compound interest working against you it can have a very negative effect, as with credit card debt. As J. Reuben Clark has taught: “Interest never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels; it takes no pleasure; it is never laid off work nor discharged from employment; it never works on reduced hours . . . it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once in debt, interest is your companion every minute of the day and night; you cannot

 

But compound interest, when it is working for you, can help you to build amazing wealth. It’s because of this amazing power of compound interest that it’s important to begin investing as early as possible and as much as you can. So, for example, if you start to invest $200 a month toward retirement at age 25 and invested that amount for 40 years and earned an average annual rate of return of 12 percent, which is very doable over the long term, then you would have $2,061,942 at retirement! And that’s investing just $200 per month. The average family in America spends more per month than that on eating out. So if you turned eating out into an occasional treat like it used to be, you could fund your retirement from just that one change alone.

But let’s look more closely at how important it is to start saving early and not procrastinate. This idea is shown really well by a graph like this one:

Jessica and Melissa what is compound interest graph

This graph shows very clearly the need to start investing as soon as possible for retirement in order to take advantage of compound interest. In it we see that even though Melissa invested far more over time than Jessica, because she started 10 years later, she never ended up with as much as Jessica. In fact, she didn’t even come close—Jessica ended up with almost $1,000,000 more than Melissa. Does that help you to see how vital it is to begin to save early and just stay the course? Most people really can find $200 a month in their budget, especially if they follow my 21 suggestions for ways to reduce your spending and also work on these 11 best ways to increase their income.

How can I best use compound interest?

As mentioned above, the best way to take advantage of compound interest is to invest as much money as possible as soon as possible. Besides doing your part by investing early and often, you should try to find the investments with the best rates of return possible (I share below the approach we use for investing our money, in case that’s helpful). That’s why it’s better to invest in stock mutual funds than in bonds, for example, because historically stocks have outperformed bonds over the long term.

You should also work to pay off your debts as soon as possible so that you don’t have compound interest working against you and so that you have more money available to invest for retirement. In order to pay your debts off more quickly, use a debt payoff acceleration plan—either the debt snowball approach or the debt avalanche approach. The debt snowball is where you list all of your debts in order from smallest balance to largest balance, and you pay them off in that order as quickly as possible. With the debt avalanche method, on the other hand, you list all of your debts in order from highest interest rate to lowest interest rate, and you attack them in that order. Mathematically, the debt avalanche will save you the most money in interest, but debt is not just a matter of math. If it were, no one would be in high-interest credit card debt! So I recommend that you use the debt snowball method. However, if the debt avalanche method is what will help keep you motivated to stay the course and get out of debt (become debt free!), then use that method if you prefer.

 

Related articles:
Roth or Traditional IRA—Which Is Better?
How to Retire a Millionaire by Investing Just $200 a Month!
How to Save Enough Money to Fully Fund Your Roth IRA
Why You Need to Start Saving for Retirement Right Now!

 

How can I start earning compound interest?

For most people, the best way to start taking advantage of compound interest is to participate in your company retirement plan, such as a Roth 401(k), where you receive a company match. If you do not receive a company match, or once you have invested enough to receive the company match, then the next thing you should do is to open a Roth IRA and invest the remainder of your budgeted amount (it should be 10 to 15 percent of your income—if you can’t invest that much now, start where you can, and work your way up to that amount) for retirement.

Have you been putting off opening a Roth IRA because you thought it might be too difficult or time consuming? Fill out the info just below and I’ll send you a simple cheat sheet to show you how to open a Roth IRA in 10 minutes or less.

 

Has this article gotten you excited to start investing? When you do start to invest, I recommend that you sign up for a great free app called Personal Capital in order to track your progress toward reaching your retirement and other financial goals. With Personal Capital, you can see not only all of your bank checking and savings accounts and even your credit cards and other finance accounts, but you can also link your retirement and regular nonretirement brokerage accounts. This allows you to have a complete, overall picture of your current financial situation. And you can also view your account history to see how your accounts and overall portfolio have done over time. I love this very helpful tool and use it regularly! Sign up for your free Personal Capital account here.

 

Conclusion

Isn’t the topic of compound interest fun? Isn’t it powerful? I’m glad you agree! 😀 By taking advantage of compound interest, you can start to build long-term wealth to help ensure that you have a comfortable and wonderful retirement. And once you are able to save money in addition to retirement by reducing your spending and increasing your income you can also start to invest for other long-term goals, as well, such as saving for your children’s college educations or purchasing paid-for rental property.

Doesn’t knowing the power of compound interest make you just want to whip your finances into shape so that you can start investing ASAP to take advantage of that amazing power? Good! So let’s get started! Join the free Save Your Money, Change Your Life 7-day challenge today!

Invitation to Share

Was there something in this article that inspired you to change something about your money? Are there ideas or tips that you feel could help others? Would you please take a minute to share this article via email or social media? I would love your help to share these principles of financial well-being. Thank you!

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what is compound interest and how does it work