Whether you’re saving or investing, you probably like getting a return on your money.
But how about getting a return on that return – indefinitely?
That’s the concept behind compound interest. Most simply, It’s interest that you are paid on the interest you have already earned, over and over again. It’s important to understand, because it illustrates perfectly how saving or investing a modest sum now that earns compound interest can grow rapidly over time. At any positive interest or investment earnings rate, the more frequently that your money is “compounded” by earning interest, the more you’ll have.
But it’s also a double-edged sword. If you have debt like credit cards, that amount also accumulates at a compound interest rate. If you carry an amount you owe into the next compounding period (the next month, for example), all of that remaining debt will be subject to another finance charge at your current interest rate.
How compound interest works
Here’s an example that explains the power of compound interest rates:
Let’s say you invest $1,000 today at a 5 percent annual interest rate. After one year, your investment will grow to $1,000 x 0.05=$1,050, representing your original $1,000 and $50 of interest.
After two years, the next compounding will be assessed on the new amount of $1,050, giving you $1,050 x 0.05 = $1,102.50. You’ve earned 5 percent interest on the $1,000 – and on last year’s interest payment of $50. So, in two years your $1,000 has earned you more than $100.
You probably get the idea – each year your new total is multiplied by 0.05, and that amount compounds your investment (this is also called geometric growth).
The fun really starts when you project it out even further into the future. Look how your $1,000 grows over time:
- After 5 years: $1,276
- After 10 years: $1,629
- After 20 years: $2,653
- After 30 years: $4,322
That’s right – by doing nothing other than letting your original investment accumulate, it has grown by more than four times in 30 years due to compound interest.
And remember -- this is how much it rises without you adding a dime of your own money after your initial investment. Investment amounts can really take off when you also contribute at regular intervals. In effect, you’re adding fuel to the friendly fire of compound interest.
Consider, for example, saving that original $1,000 at 5 percent, but also adding $50 every month to the account. At the end of 10 years, you’d have $9,378. In 30 years, that total would amount to $45,527.
Pretty compelling, right? This is the essential philosophy behind saving for retirement. With regular contributions over your entire working life, you build a substantial nest egg that can support you during your nonworking years. If you’re interested in seeing if you’re on track with your savings try our retirement calculator and find out for free.
But you don’t need to be angling for retirement to benefit from the concept of compound interest. Your only job is to leave your interest earnings untouched in your account and start watching it grow over the years. One way to get started is to explore the various robo-advisor investment platforms available on the market today. To learn more about robo-advisors, check out our top 6 robo-advisor picks for Fall 2016.