Recently, I covered a really basic but powerful concept – dollar cost averaging. Here's another powerful money and investment concept everyone should know – compound interest.
What is compound interest?
Albert Einstein once said that compound interest was the most powerful force of all time. He was a pretty smart guy!
Compound interest is really a math concept that shows the power of making interest on not just your principal but also interest. If you have $1000 and you make 5% interest, after the first year, you will have $1050. If you let the interest compound, the second year you will not make $50 of interest again but rather $52.50 of interest because you are making 5% off the $1050. In other words, you made and extra $2.50 of interest on the $50 of interest from the previous year. After the second year you will have $1102.50. In the third year, you will have $1157.63
Three ways to calculate compound interest
- Spreadsheet. The first is to use a really simple excel spreadsheet. Here’s one that I put together. You can just plunk in your numbers and out spits the compounding effect of a single lump sum. Simple compound interest spreadsheet (3225 downloads)
- Financial Calculators. There are many different financial calculators on the web including calculators for compound interest. The one I have bookmarked is one that I have used to teach my kids about compound interest. If you are investing a series of regular investments instead of one single deposit, I use a calculator from Mackenzie Financial
- The rule of 72. The rule of 72 is an easy way to estimate the effect of compounding. Basically the rule of 72 works like this. Take and interest rate like 5% and divide this number into 72. 72 divided by 5 equals 14.4. The answer is the number of years it take for money to double. In other words, $1000 at 5% will double to $2000 in 14.4 years. At 6%, it will only take 12 years for money to double in value. A 1% increase in interest rate cuts the time frame by 2.4 years.
Keys to making compound interest work for you
1. Time – Compounding is every investors best friend because it basically suggests that the sooner you start, the sooner you can get your money working in your favour. Check out this amazing story on why it is so important to start investing early.
2. Frequency – In the example at he beginning of this article, I compounded the returns annually. In other words, you earn interest on interest yearly. If I calculate the growth of $1000 at 5% compounded annually, I will get $4321.94 at the end of 30 years. The more frequent I compound, the more money I will have. If I calculate the growth of $1000 at 5% compounded monthly, I get $4467.47 at the end of 30 years. The more frequent compounding happens the faster money make money on money. Here’s the growth of $1000 at 5% after 30 years at different frequencies:
- compounded annually – $4321.94
- compounded semi-annually – $4399.79
- compounded quarterly – $4440.21
- compounded monthly – $4467.47
- compounded daily – $4481.23
- compounded continuously – $4481.69
If you want to learn more about the math of compounding frequency, investopedia has a great article:
3. Interest rate – Obviously, the higher the interest rate the faster money grows. In the example above, if I use 10% instead of 5%, the results are shocking. Here’s the growth of $1000 at 10% after 30 years at different frequencies:
- compounded annually – $17,449.40
- compounded semi-annually – $18,679.18
- compounded quarterly – $19,358.15
- compounded monthly – $19,837.40
- compounded daily – $20,077.29
- compounded continuously – $20,085.54
Doubling the interest rate more than quadruples the result. That’s powerful.
4. Regular investing – The last key to making compounding work for you is to save regularly. If you can put away money every month and be consistent about it, money grows that much faster. In all the examples above, I show the compounding effect of a single deposit or investment. If you invest $1000 every year for 30 years, you will have $69,741 after 30 years (at 5% compounded annually). That’s why group retirement savings plans are such a great way to save and take advantage of compounding.
Compound interest is very powerful when you understand it. It’s an old concept but such an important one to know.