The Power of Compound Interest
You earn interest when you put money into a savings account. Through compounding your interest grows faster. The sooner you start saving, the more compound interest you’ll earn.
Compound interest is based on your deposit amount and the accumulated interest you earn. It is “interest on interest” and the secret weapon of young savers (and investors!).
What is interest? Interest is often called the time value of money. When you put money into a savings account, you’re postponing your use of it and allowing the bank to lend out your money to earn its own interest. The bank must compensate you for allowing it to hold and lend out your money―that compensation is interest. Fundamentally, it reflects how much additional money you demand to induce you to postpone spending.
Simple vs. compound interest. We express interest as a percentage of a principal amount. Simple interest is that percentage applied to your initial principal. For example, suppose you open a savings account with $1,000 that pays 2% simple interest every year for 10 years. You’d earn 2% of $1,000, or $20, each year, for a total of $200. In contrast, compound interest would add each year’s interest to your previous principal. So, after the first year, your new principal would be $1,020. In year two, you’ll earn 2% on $1,020, or $20.40, giving you a new principal of $1,040.20. You earn another 2%, or $20.80, in year three, bringing your principal to $1,061, and the pattern.
Faster compounding is good. In our example, 10 years of simple annual interest would earn you 10 x $20, or $200, and yearly compounding would earn you $218.99.1 But if your interest compounded monthly, you’d earn $221.20. Better yet, daily compounding would produce $221.40 in 10 years. Extending the period to 20 years would earn you $491.81 (with daily compounding) and $822.09 after 30 years. In other words, the longer you let your money compound, the faster it grows. That’s why young savers and investors have a huge advantage over older folks.
Getting real. You will likely commit a portion of your money to investing. Suppose you started at age 25 with $1000 in an IRA mutual fund that grows on average by 7% per year. In addition, you contribute $200/month to the investment and automatically reinvest all your earnings, dividends, and capital gains. That’s real earning power, and it would be even stronger if you increased your monthly contributions and/or averaged more than a 7% return.
Now’s the time to start socking away your retirement nest egg. Consistent investing over a long period has the potential to produce significant results, thanks in part to the power of compounding. However, many other variables apply, including your investment strategy, returns, and taxes. Call me if you’d like to review your financial plan or set one up. Together, we’ll put compounding interest or earnings to work for you.
This compound interest and earning examples used are hypothetical and not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
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This material was prepared for Chris Larkin and does not necessarily represent the views of the presenting party or their affiliates. This information has been derived from sources believed to be accurate. Please note—investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting, or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax, or legal advice and may not be relied on for the purpose of avoiding any federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.