Ever wonder what it means when a financial professional mentions the words “compound interest?” You’re not alone, even Albert Einstein called compound interest “the eighth wonder of the world”. Yes, it sounds complex, but it’s one of the most beneficial principles of investing which, when applied correctly, can help everyone prepare for retirement and save money.
Compound interest – means to produce earnings from previous earnings, or gain interest on interest. This differs from simple interest, which is the amount of interest calculated by a single sum with no provision for adding that interest to the total amount. Below is a graph illustrating the basic differences between the two.
Over time, compound interest means your earnings are earning you more. The longer the time period, the more your investments will earn. Since 1934 the S&P 500 has returned an average of 8.7% adjusted for inflation and including dividends. Remember that this is a long-term number over 80 years. Short-term fluctuations can see higher or lower returns depending on the current economic cycle. You can use a return calculator like the one at moneychimp.com to see how your invested funds would have grown in the S&P 500 with historical values.
Here is how compound interest can work for you:
If you invest $100 with an interest rate of 8%, compounded annually, during the first year, you would gain $8 on your investment, bringing your total to $108.00. But, if you let that investment sit and earn the compound interest, at the end of the second year, you would gain $8.64 on the $108.00, giving you a total of $116.64. And, if you let your investment sit, at the end of the third year, you would gain $9.33 on the $116.64, giving you a total of $125.97. Your money increases by not touching it. It sounds like Einstein was onto something.
While $100 does not seem like a big investment, if you invested $100 and never added anything to it and it grew at 8% a year for 40 years, your $100 investment would grow to $2,172.45.
Even more impressive would be to began an initial investment of $100 and faithfully add $10 each month. At the end of 40 years, you would have $33,259.23!
As you can see, compound interest favors the young prudent investor because time is the number one factor in maximizing compound interest.
Clearly, prudently investing and leaving your investments untouched will give you a better-than-average chance to build wealth. As you look ahead and plan your investment future, understanding the value of combining small additions to your investment portfolio, along with the power of compound interest, will produce a healthy personal financial profile.
Jonathon Rowles Captain, USMC (Ret.)
Disclaimer: (have to do it) – This blog should not be considered financial, investment, legal or tax advice. Consult your licensed financial professional, tax advisor or legal counsel. This blog is for educational purposes only.