Compounding Interest 101 | A Must Know for Investing

Compounding InterestEver wonder what Compound Annually or Compounding Interest means? You’ve probably heard others talk about it as part of their financial planning. I used to think it was some fancy word for rich people when they talked about living off their interest. I wouldn’t mind doing this myself btw. About 7 years ago I learned that we all can make our money compound annually. If you’d like to know how keep reading and learn about compounding interest and how it plays a part in your financial security.

When I got out of high school I said there’s no way I’m going to work till I’m old. Then I started working and wondered how I was ever going to get to stop working if they didn’t pay me enough to save for it. And there’s the kicker. You may not get paid enough, but you can most definitely save…..at least some or hopefully more.  But should you invest in a Roth IRA, Traditional IRA, 401k, Roth 401k, Target Retirement Fund, financial portfolio or maybe become a day trader? Good question, but one thing all of these have in common is they work off the principal of compounding interest. So before you learn about those investment options you must first learn and understand how compounding interest works. And by learning this you will want to seize the day and be on your way towards financial freedom.

Consider this:

If you started today, putting aside $100 every month and it compounded annually at a 7% rate of return, after 30 years you’d have $121,287. Or you could lock that up in a box under your floors and in the same amount of time it’ll total up to a whopping amount of only $36,000. See the difference? Which one truly helps towards financial security? (If you want to put in your own values, All Things Finance has some great financial calculators.

Still not sure how compounding interest works? Don’t worry, I didn’t get it the first time I heard about it.

This example helped me wrap my brain around it.

First year: $1200 ($100 month) x 7% = $84 in interest

Second year: $1284 (1st yr) + $1200 (2nd yr) x 7% = $173.88

At the end of the second year you’ll have $2657.88 total when you only put in $2400. Follow this for 30 years and you’ll have $121,287…..don’t save early and in 30 years compounding interest will no longer be an option. This is a simplified example. In reality there are other options like monthly, quarterly, bi-annually compounding that you’ll need to consider. But the goal is to understand compounding interest and make it work for you.

Want to know how long it’ll take for your investment to double? It’s called the rule of 72. All you have to do is divide the rate of return (aka interest rate) into 72. The result is an estimate of how long it’ll take to double your value. For example 72 divided by 8% (interest rate) equals 9 years to double whatever amount you started with.

So what’s the deal? Why does it sound so simple yet all I hear is how everyone at retirement age hasn’t saved enough for retirement. Is the problem compounding interest or that people aren’t saving enough? Well, it’s a bit of both. The biggest catch to compounding interest is that the younger you start the more years your interest compounds and the more you have saved in the end. So you really do want to start now.

According to standardandpoors.com, from January 1970 to December 2009 (30 years), the average annual compounded rate of return for the S&P 500, including reinvestment of dividends, was approximately 10.1%. The S&P 500 is a good example because it is an INDEX fund that’s comprised of the top 500 leading companies in leading industries of the US Economy.

If you’re still with me hopefully you’re considering or have already decided to start saving. Maybe you have a goal to buy a home or not rely on social security for retirement. I can’t stress enough how important it is to start now. Even if it’s only $50 a month. There are always daily or monthly expenses you can cut out.

Here’s a couple fun facts:

Albert Einstein called compounding interest, “The greatest mathematical discovery of all time”.

Warren Buffett, the founder of Berkshire Hathaway, started with only $9800 in 1955 and today is worth $44 billion. In the April issue of ForbesLife magazine he said, “The thing is, when I got out of college, I had $9,800, but by the end of 1955, I was up to $127,000. I thought, I’ll go back to Omaha, take some college classes, and read a lot–I was going to retire! I figured we could live on $12,000 a year, and off my $127,000 asset base, I could easily make that. I told my wife, “Compound interest guarantees I’m going to get rich.”

Editor’s Note: John is not a registered financial advisor and writes from his personal experience through reading, studying and managing his own finances. All of our financial situations are different and this is just a basic introduction for your own personal knowledge.

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About John

Passionate. Life Learner. Thinker. Christ Follower. Investor. Conversationalist. Army Veteran. Dog Lover. Corporate Colleague. Bears, Blackhawks, Cubs fan. Follow me on Twitter.

Comments

  1. Glad to see a post that shows the power of compound interest. It becomes even more important when you add in the fact that inflation is eating away at your money to the tune of 2%-3% most years. If you aren’t getting in on the compound interest action the buying power of your money will be suffering.

  2. Compounding interest is pretty powerful. The big problem is that young people don’t truly appreciate it. So most don’t start saving as early as they really could. While they’re young they feel obligated to spend all their money and have some fun. The last thing on their mind is that they should be saving some of that money to use in 40+ years down the road.

    • Haha! So right! I wish I could say I wasn’t one of those young people. I didn’t save a penny until I was 25 so now I’m making up for that. Those 7 years after highschool I could of afforded at least $50.

  3. Great stuff my friend, although i’m already as old as dirt, i would love for my money to make money for me. I need to know where this sort of thing takes place though! every bank iv banked at has told me that my money cant make money like that. It would only get 1% at the most. Help me out son!

  4. Jonathan’s making the mistake of thinking too short term, I think. Over longer periods of time he’ll see this is more of an anomaly than the way things will be forever.

  5. Hi, John. I discovered this article through your submission via the Blog Carnival. Compounding interest is a powerful way of growing your money and I think it is often underrated. I’ve always believed in the awesomeness of compounding interest and I am glad you have this article to introduce the idea to the readers. I will definitely include this excellent article in my blog in my upcoming blog carnival. Thanks, John.

    • Thanks dude! Learning Compounding Interest changed my way of saving and investing and I know it can do wonders for others too.

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