What is Compound Interest?

| July 31, 2013 | 0 Comments

Compound interest is interest that adds onto the principal and the previous interest earned.  Simple interest only accrues on the principal and not previous interest payments.  Compound interest grows much faster than simple interest because it is earned (or paid) on a rising balance.  The more frequent the interest is compounded, the quicker the balance grows.

When I was very young, my dad illustrated the power of compound interest with a very simple example.  He asked me how much I thought a penny could grow if he gave me a penny on June 1st and it double each day after for the full month.  I guessed a few thousand dollars.  He said higher.  I raised it to $10,000, then $50,000 and he kept saying higher.  So his anecdote didn't last all day, he fessed-up.  A penny that doubles the previous day's value each day will equal $5,368,709.12 after 30 days.  February's total would only reach $1,342,177.28, unless it was a leap year.  I was floored that in just two extra days, the difference would be more than $4 million.  Maybe this was the first seed planted in my path to become an Investment Advisor.  I'm still impressed with the magnitude of the gains that started with one cent of interest.

This is a classic example of the importance of investing early and letting time and interest work for you.  Since I don't think many seven or eight year olds are reading this story, I'm going to elevate it some.  Instead of allowing the penny to double every day and build on itself, what if you took out half of the gains to spend.  That one cent would grow by 1.5 each day instead of doubling.  The difference is staggering.  After 30 days of spending half of what you earn in interest, you would finish the month with only $1,278.34.  That is close to 1/50th of 1% of the amount earned without deducting spending.

These examples magnify the effects of compound interest and spending to make a point.  The point can be made with a more realistic example of compound interest that illustrates the need to save early and often.  If co-workers who earn the same income approach saving, investing and spending in slightly different ways, the results are massively different.  The employee who saves $10,000 every year from age 25 to 60 and earns 8% each year will have $1,723,168.04 after 35 years.  The employee who waits until age 30 to start saving will have $590k less at age 60 and will have to continue working while the first employee can retire with $86k per year in investment income (assuming a 5% annual rate of return during retirement).  If a third employee invested $10,000 the first year only and spent the other $10k each year instead of saving it, he will only have $136,901.34 by age 60 and shouldn't plan on retiring until he is in his 80s.

Compound interest is an investor's friend and a borrower's enemy.  By staying out of debt, living beneath one's means and saving on a regular basis anyone can reach retirement by a reasonable age.  Retiring while you still have your health and some youth left sounds much more appealing than having to work through your 80s.

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