When my niece was in second grade, I took her to the dentist. I told her that if she were good while they extracted her baby tooth, I’d reward her with a treat from TCBY. That was five years ago. Last week my niece reminded me, as kids do, that I still owe her TCBY. But now, instead of one treat, I owe her three.
“Why is that?” I asked her.
Her response? “Because compound interest.”
When it comes down to it, my sweet niece really wasn’t all that far off. If we had laid things out in writing, viewing her TCBY treat as a $5 investment, she’d definitely have enough for more than one treat by now. This, my friends, is the power of compound interest.
What is compound interest?
Technically speaking, compound interest is not a multiple of the number of treats your lying Aunt owes you after several years, but the amount of money you can earn overtime by reinvesting your interest and making money on that interest. It’s calculated by tracking your principal investment times the interest rate raised to the number of compounding periods. Let’s look at an example:
It’s 2020 and I have $1,000 that I’m planning to invest in an exchange-traded fund (ETF) where I’ll conservatively assume that I’ll receive a 6% return compounded monthly.
Using a simple (kinda?) formula:
Where A is the final amount, P is the initial principal (1,000), r is the interest rate (.06), n is the number of times interest is applied per time period (12) and t is the number of time periods elapsed (10).
Keep in mind this considers no additional contributions during the 10-year timeframe. It’s a simple set it and forget it example.
After performing the calculations for r/n (.06/12 = .005) and n*t (12*10 = 120) we’ll be multiplying the principal by 1.81939 (1.005 to the 120th power).
When all is said and done, with everything remaining consistent, my $1000 investment in 2020 has the potential to turn into $1819.39 in 2030.
Well, that’s nice, but that’s not very much money.
How right you are. Where compound interest starts getting fun is when you consider larger sums of money and those which you continuously contribute to over the years.
How can I easily calculate compound interest?
The formula above is great for manually computing smaller, static amounts. But as situations grow in complexity, I like to turn to the experts for tools that help calculate compound interest easily. Bring on the calculators.
- NerdWallet, as usual, has a fantastic calculator that quickly shows how contributions grow over time.
- Bankrate’s calculator has all the same inputs as NerdWallet but offers sliders in addition to input fields. It provides easy access to see the impact of changing interest rates and contribution amounts.
Why should I care about compound interest as an investor?
Compound interest is an investor’s best friend. One of my personal goals is to let my money make money for me and not have to worry about contributing to it anymore. I certainly hope many of you feel similarly. Let’s take a look at a few more scenarios that show the power of compound interest on more sizable investments over time.
Compound interest is impressive in both taxable and non-taxable accounts. But the benefits of investing your money in an after-tax Roth IRA means you take advantage of compound interest and tax-free growth!
- With an initial deposit of 10,000, monthly contributions of $100, a 5% return rate, and annual compounding, you’d have yourself a cool $31,391 after ten years.
- An initial deposit of $3,000, monthly contributions of $250, a 6% return rate, and annual compounding could turn into $81,845 after 15 years. $31,845 of that is pure interest!
- Starting with just $1,500, monthly contributions of $300, a 7% return rate, and annual compounding has the potential to grow into $153,465 after 20 years. At that point, you’d have more in interest than you paid into the principal. See, I told you it starts to get fun, right?
Invest early and often
The bottom line is that to take advantage of compound interest; it’s advisable to start investing early and often. I wish more than anything that I had known the power of compound interest when I got my first job in high school. Putting away a small amount of money monthly starting 15 years ago could have changed my current situation in a big way.
I encourage you to share this article with someone in your life who is just starting their personal finance journey. Being able to visualize how investments can perform over the long-term is a great way to encourage younger investors to start early.
Do you have other thoughts on the wonders of compound interest? I’d love to hear about it in the comments.