Compound Interest for the Win!

Have you heard about compound interest before? Maybe you learned a formula long ago in a math classroom somewhere, but do you actually know what it is? Compound interest was famously called the 8th wonder of the world by Albert Einstein, and he was a pretty smart guy! It is much more than a math formula that you had to memorize once, it has the power to transform your financial life.

So, what is it? Compound interest is what happens when interest accumulates on your principal (the amount of money you put into the account), as well as any interest that has accumulated previously. That means your earning interest on interest! Let’s look at an example:

Let’s say you deposit $100 into a savings account that pays 1% interest per year. With interest that does not compound (this is called simple interest), you would simply earn 1% of $100 every year, thus your balances would look like this:

Original Amount: $100

After 1 Year: $101

After 2 Years: $102

And so on.

With compound interest, the interest you earn would build on itself:

Original Amount: $100

After 1 Year: $101

After 2 Years: $102.01

You get an extra cent because you earned 1% on your $100 plus 1% of the dollar you earned in interest the previous year. Woo hoo! A whole cent extra!

So what’s the big deal? Well, compound interest is admittedly not that exciting over a short period of time, but your money will grow exponentially in the long run. This means the longer it is deposited, the faster it will grow. 

Financial advisors often use the Rule of 72 to estimate how much a client’s money will grow with compound interest over a certain time period. The rule states that you can approximate how long it will take your money to double by taking your interest rate divided by 72. This means if you were earning 10% in your account, it would take approximately 7.2 years (10 ÷72) for it to double. 

Let’s take it a step further; if I started out with $10,000 in my 401k, earning an average of 10% per year at age 25, using the rule of 72, my balances would approximately look like this:

Age 25: $10,000

Age 32: $20,000 Increase of $10,000 in 7.2 years

Age 39: $40,000 Increase of $20,000 in 7.2 years

Age 46: $80,000 Increase of $40,000 in 7.2 years

Age 53: $160,000 Increase of $80,000 in 7.2 years

Age 61: $320,000 Increase of $160,000 in 7.2 years

Age 68: $640,000 Increase of $320,000 in 7.2 years

Can you imagine making $320,000 in 7.2 years simply by leaving money in an account with compounding interest? That is amazing and worthy of the title “The 8th Wonder of the World”. To learn more about investing and compound interest, check out our Dollars + $ense blog at www.roguecu.org/learn