You’ve probably heard the saying, the early bird gets the worm.
When it comes to your money, it’s more like the early bird gets the compound interest. It doesn’t quite have the same ring to it, but you get the picture: saving and investing early is essential for long-term growth and building wealth, especially with compound interest.
At its core, compound interest is the interest you earn on your interest. Harnessing this power can take your savings and investments to the next level. That said, as much as compound interest can help you build wealth, it can hurt you just as powerfully when accumulating debt. In this article we’ll cover:
- What is compound interest?
- How does compound interest work?
- How does it apply to you and your money?
Let’s get compounding!
Financial knowledge is for everyone.
First, Establish the Basics of a Robust Portfolio
While compound interest can be like Miracle-Gro for your investment accounts, there’s no point in growth if you don’t establish a healthy foundation.
Doing so is like trying to grow a plant in the wrong soil and climate. No matter how much fertilizer, water, or weed preventer you use, the plant likely won’t make it.
How can you give your investment strategy a rich starting place?
Create an intentional, long-term portfolio. To do that, consider the following:
- Your goals. Establishing your “why” enables you to bring more care and intention to your investment strategy. When you know your goals, you can make well-informed decisions to reach them.
- Time horizon. How long will it take you to reach your goals? Saving for retirement can take decades, saving for your child’s college education is about 18 years, a down payment on a house might be five years or more. Knowing how long you have to invest can inform other elements of your strategy, like the best accounts to invest in, how much to invest, and the type of investments you choose.
- Your risk tolerance. This is your willingness to take risks in your portfolio. Think about it like this: how much of a portfolio dip is comfortable at any given time? What temporary losses would still allow you to sleep at night? You and your advisor can tailor your asset allocations to your risk preferences.
- Asset allocation. You won’t invest for each goal the same way. Your asset allocation represents the mix of investments you buy (Exchange-Traded Funds (ETFs), index funds, bonds, etc.). For example, your asset allocation may be more equity heavy as you prepare for retirement, setting yourself up for the most growth and having time to weather a market storm or two.
Once you’ve constructed a portfolio you can take the long view, sit back and relax, and let compound interest take control.
What is Compound Interest?
Before we start compounding things, let’s briefly review what “interest” means.
Interest has a dual meaning: the amount you receive from leaving money with a bank or other institution, like a savings account, certificate of deposit (CD), or investment account; it is also the amount you owe when borrowing money, like a student loan, mortgage, or other debt.
There are two types of interest, simple and compound.
Simple Interest, Explained
Simple interest is the more straightforward of the two. This type of interest is also known as flat-rate interest because the interest calculations remain the same over time, using the original principal balance.
Say you work with a bank that pays simple interest (rare). They will always base the interest on your original account balance. If you have a $10,000 deposit with a 3% interest rate, you’ll earn $300 in interest each year. Here’s what your account would look like over three years with simple interest:
- Year 1: You’d earn $300 in interest, bringing your account value to $10,300.
- Year 2: You’d earn $300 in interest, making the account worth $10,600.
- Year 3: You’d earn $300 in interest, and the total balance would be $10,900
Simple interest can benefit borrowers because it keeps your payments lower over time. It’s common to see auto loans or personal loans adopt this framework.
When it comes to earning money, compounding interest is undoubtedly the way to go.
Compounding Interest, Explained
Think about compounding interest like interest that grows on top of interest. It’s the money an institution pays you plus what your interest earns over time.
If that sounded confusing, here’s an example of how compound interest works.
Say you have $10,000 in a high-yield savings account and the bank pays you a 3% interest rate that compounds annually:
- Year 1: You’d earn $300 in interest, bringing your account value to $10,300.
- Year 2: You’d earn $309 in interest, bumping your account to $10,609.
- Year 3: Your interest jumps to $318.27, and your total account balance would be $10,927.27.
As you can see, your account would earn more even in the short-term with compound interest instead of simple interest — in this case, a difference of about $30. With compound interest, your principal balance grows faster and allows more rapid growth long-term.
How quickly your balance will grow depends on several factors:
- Your initial investment
- Ongoing investments
- Interest rate
- Frequency of compounding
Interest can compound at a few rates: daily, monthly, quarterly, or annually. In general, the more frequently the interest compounds, the quicker your balance will grow.
You can truly see the magic of compounding interest over long periods. Here’s an example using a compound interest calculator.
Say you’re investing in a brokerage account. You received a generous $10,000 year-end bonus and put the whole thing in that investment account. Each month, you plan to contribute $500. Assuming a 6% return compounded monthly, your $10,000 is projected to grow to $565,071 in 30 years.
It’s incredible to see the power of compounding interest in action, and this example highlights its impact on long-term investing. Leveraging the value of compounding interest is one reason why investing early for significant goals like retirement, education, career changes, time off of work, house, car, etc., is so beneficial. You can watch your bounty grow over time without touching the account.
The Formula for Compound Interest
While you can use several online compound interest calculators, you can also haul out a pencil and paper to do it manually with a simple formula:
A = P(1+r/n)^(nt)
A = The initial balance
P = Principle amount
r = Rate of interest
n = Compound frequency
t = How long you invest/borrow the money
Let’s put these letters to work with an example.
You put $5,000 (P) into a 5-year (t) CD that pays a 2% interest rate (r) and compounds daily (n). Now plug those numbers into the formula and make your high school algebra teacher proud.
After 5 years, you can expect your account to be worth $5,525.79, so you earned over $525 in interest.
Compound Interest Can Help You Reach Your Goals
Your goals should be the foundation of your investment strategy. They guide the direction of creating and maintaining your portfolio long-term. Let’s dive into several common financial goals and how compound interest can be your best friend on the path to achieving them.
Compound Interest and Retirement
Retirement is perhaps the most significant savings goal of your life. Few other goals ask you to diligently save thousands of dollars a year for over 40 years. But even though proper retirement saving is a big ask, the reward is equally considerable: financial independence.
How can compound interest help you on your retirement savings journey?
Saving for retirement requires a myriad of investment vehicles — workplace plan, IRA, and brokerage accounts. We’ll focus on one of the most common plans for this exercise, a 401(k).
For this scenario, let’s dream big and assume you start contributing to your 401(k) by 25. You have a generous starting salary of $60,000 and contribute 10% each pay period. You’re also lucky enough to have a company match (100% on up to 3% of your contributions). Using a 401(k) calculator, your $0 401(k) at 25 is projected to be worth over $2.2 million by the time you’re 65.
But even if you waited five years and started investing at 30 with a higher base salary of $70,000, the account would only be worth $1.7 million given the same scope. That’s a difference of nearly $500,000! So saving early and consistently can really pay off.
Compound interest can’t take all the credit. Your investment allocations, diversification, risk levels, rebalancing, and more play a significant role in your account’s long-term value. But by investing consistently, you give your investments time to grow, compound, and provide for you when you need them.
Compound Interest and Education
Another common financial goal with a serious price tag is education.
Many families want to make children’s education savings a priority. Whether private schooling, undergraduate degree, graduate school, or a combination, it takes a disciplined strategy to save enough money to reach your educational goals.
This is another area where starting early and compounding interest can come in handy. Here’s an example.
Say you recently had a child. By the time they are one, you know you want to start investing for their future schooling. It’s important to you to cover the essential costs of their undergraduate education (tuition, fees, room, and board), so you decide to open a 529 Plan. Let’s see how much you’d need to save to meet your goal by using a college planning calculator.
Based on current tuition rates for in-state, public 4-year institutions, you’d have to invest about $500 a month to accumulate over $220,000 when your child starts school at 18. By investing consistently for 18 years, you give the money in the account the chance to benefit from compounding interest, which helps you reach your goals.
Remember, investing for retirement won’t be the same as investing for education or other goals throughout your life. It’s important to consider creating strategic investment plans for each goal and prioritize when necessary.
Stay Off Compound Interest’s Bad Side
There’s a good and a bad side to everything, including compound interest.
Where compound interest can feel like magic when growing your investments, it can feel defeating when you’re knee-deep in high-interest debt, like credit cards.
Since credit cards come with sky-high interest rates — the current average interest rate for new card offers is 18.32% — if you don’t pay off your balance every month, you’ll end up far deeper in debt than you realized.
The bottom line is to stay on compound interest’s good side and pay your credit card bills in full every month.
Compound Interest Takes Your Money Into a Bright Future
Knowing what compound interest is and how it works can give you a deeper understanding of the value of saving early. The earlier you save, the more time your investments have to take advantage.
Compound interest is yet another way to make your money work for you. Remember how hard you work to earn your paycheck? Be sure your money puts in the same amount of work to help you secure the future you’ve been dreaming of.
Remember, in personal finance, it pays to be early.
The earlier you save, invest, budget, pay off debt, and cultivate healthy financial habits, the more confident and content you’ll be on the path to success and happiness.
Are you taking full advantage of the power compound interest can bring to your portfolio? Set up a call with an Abacus Advisor today and let us help build a comprehensive investment plan that’s meaningful to you.