Compound interest is the most powerful force in the universe. If you don't believe that, will you believe its the 8th wonder of the world? Albert Enstein even said so:
“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
I can’t argue with one of the smartest brains of the 19th century.
Compound interest is perhaps one of the most thrown around words when it comes to investing, but do you really understand it?
A survey from ValuePenguin reveals that nearly seven (69%) out of 10 Americans don’t understand compound interest. Here's your chance to learn more about compound interest so you don't miss out on its benefits.
What is compound interest?
When you deposit money in an interest-bearing bank account, the bank pays you a little bit of money to keep your cash there. That’s simple interest. Why do they pay you? Because they use your money when you aren't using it to lend out to people and businesses.
Compound interest is when you earn interest on the money you were paid for interest, causing a compounding effect. The interest paid to you becomes part of the principal during the next interest cycle.
In our example, the bank not only takes into account your principal deposit, but it also considers interest paid during the last cycle as a part of your new principal amount.
How does compound interest work?
Now that you know what compound interest is, let’s take a closer look at how it works. As an investor, compound interest works in your favor to increase your wealth. If you refrain from spending your investments, or withdrawing your interest, your account will grow exponentially over time.
Example of Compound Interest
Let’s say that you make a deposit of $500 in an investment account that earns interest of 12.0% per year, and has a monthly compounding cycle.
Your monthly interest rate is 12.0% divided by 12 months, or 1% per month. If you add $500 to your account every month, and never make a withdrawal, here's what your balance will be after 10, 20, and 30 years:
- After 10 years: $92,083
- After 20 years: $295,113
- After 30 years: $742,781
Did you notice that each decade your earnings more than double? Given sufficient time, even small investments can make a huge difference in your retirement. The following chart shows the growing balance over time:
While there isn't room here to show every month of the 30 years on the chart above, the chart below shows the first year of deposits and how the balance accumulates using both compound interest and simple interest.
Why Compound Interest is Important
Now that we've covered how compound interest works, let’s find out how it protects your earnings and wealth.
Compound interest builds long-term wealth.
Compound interest is critical to your investment growth is because it helps you generate wealth. We already saw an example indicating how compound interest can turn regular small investments into the kind of amounts you brag about on the FIRE Reddit website. The trick here is to have time on your side.
One way to earn compound interest is to invest in low-cost index funds or ETFs – a strategy investors like Warren Buffett believe in.
Many investors use the Boglehead formula to keep things simple. The Boglehead formula is investing 34% of your portfolio in US stocks, 33% in international stocks and 33% in US bonds.
Here are some other investment options:
- Real Estate or REITs,
- Lending Club (or other peer-to-peer lending platforms),
- and others.
You’re financially safe against inflation.
If you paid $1 for your favorite burger in 2000, you’d have to pay $1.52 for the same burger at the end of 2019. That’s because of inflation.
Inflation applies to everything. Unless your money grows at a rate similar or higher than the rate of inflation, you’ll require additional sources of income.
Compound interest ensures that your savings keep up with inflation. It becomes critical to choose a financial product that beats the effective rate of inflation.
The government uses the Consumer Price Index to adjust social security payments, dubbed as Cost-of-Living-Adjustments (COLA), in line with the ongoing inflation, so that’s a reference point you can start with.
3 Tips to boost your portfolio using compound interest
Automate your investments
The first thing you need to do is to automate your investments. There are a couple of ways to do so:
- Many companies allow you to direct deposit your paycheck into multiple accounts. Have your employer send a portion of every paycheck directly to your investment account.
- Set up an automatic ACH withdrawal from your main checking into your investment account for every pay day, or once a month.
Avoid the urge to withdraw savings
A recent survey indicates that over half of Americans dip into their retirement savings earlier than the qualified retirement age. While you may get instant financial relief, you are, essentially, robbing your future self of that money.
What makes it even worse is that you’re incurring a heavy loss in the form of the opportunity cost and time value of money.
I understand that some circumstances, such as a medical emergency, eviction, or foreclosure, require immediate financial assistance, but you must refrain from withdrawing your savings prematurely.
Financial discipline and long-term wealth go hand-in-hand
Compound interest works best when you give it ample time, as seen in our earlier example.
The best way to build long-term wealth is to practice financial discipline. The more you save, the faster your earnings will grow. To practice consistent financial discipline, its helpful to have a budget to follow.
Here are some helpful posts on budgeting:
I implore to the early-20s crowd – if you are reading this and have a job, start now. If you start your savings early and stay consistent, you have decades to take advantage of compound interest. Having this knowledge and using it gives you a huge advantage in life.
In my earlier example, I trended out 30 years of investment if you deposit $500 per month and earn 1% interest compounded monthly. If you add another 10 years, you will have well over $1M. Don't wait, start now.
Putting It All Together
Compound interest is your friend. If you’re trying to boost your savings like I am, master the art of earning compound interest. Learn more about investment avenues that offer compound interest. And above all, take action today!