The Power of Compound Interest

Compound interest is when your returns start earning returns of their own. In the first years the effect is barely visible; later it accounts for most of the capital.

Simple and compound interest

With simple interest, returns are earned only on the original amount. With compound interest, they are earned on the amount plus the returns already accumulated, so every year the gain gets bigger.

$10,000 at 7% a year with simple interest earns $700 a year and becomes $31,000 after 30 years. Compound interest looks different:

The rule of 72

To estimate how many years it takes to double your money, divide 72 by the annual return. At 7% that is about 10 years, at 4% it is 18 years, at 10% about 7.

Time matters more than the amount

Compare two people who each invest $200 a month at 7% a year.

• The first invests from age 25 to 35 and stops. In total they put in $24,000. By 65 they have about $260,000.
• The second starts at 35 and invests until 65. In total they put in $72,000. By 65 they have about $234,000.

The first invested a third as much and ended up with more — because their money worked ten years longer.

What eats compound interest

• Fees. One percent a year sounds small, but over 30 years $10,000 at 6% instead of 7% becomes $57,000 instead of $76,000. That is a quarter less.
• Inflation. Money grows in numbers, but so do prices. It is more honest to think in returns above inflation.
• Interruptions and withdrawals. Money you take out stops working, and all of its future growth goes with it.

It works against you too

Credit card debt grows by the same law, only the rate is usually far higher than investment returns. That is why expensive debt is paid off before investing begins.

The 7% return is an example and is not guaranteed. This article is educational and is not financial advice.