You Need to Understand Compound Interest

Why should you care?

If you want to be wealthy or even just retire in comfort then you need to understand compound interest.   There are three factors that determine your results -the amount of time you invest, interest rate you earn, and compounding frequency.  To make the right investment choices you should know the effects of each of these factors.  Of them all time is the most important factor.  After a year compound interest amounts to pocket change but after forty years it can amount to a fortune!  The interest rate is also critical, a one percent difference in the interest rate will make a big difference in your final totals.  Finally, there is the frequency of compounding- the quicker the better but there isn’t much difference compounding faster than monthly.

What is it?

Compound Interest is earning interest both the amount of money you invested and the interest you have already earned.   I am going to look at compound interest graphically- if you want to read about the mathematical details I recommend reading this detailed description from Dr Math.

Time (with compound interest) is money!

Time is the biggest factor with compound interest, take a look at this graph of $1000 earning a 10% return with no compounding vs compounding monthly over 20 years:years:

  • Time is a huge factor
    • After two years only $20 more
    • After twenty years it is $4328 more!
    • After thirty years the difference is $16,837

The start investing as soon as you can.  Compound interest will only help you if you invest long enough to make a difference!

Interest Rates Matter!

As you can see compounding is a good thing, and pretty dramatic with a 10% interest rate.  Suppose, you get a lower interest rate for twenty years,  how does that affect your the returns?:

  • 1% is a big difference!
    • 10% -> 9% is more than the original investment ($1318)
    • 10% -> 8% is more than 2X the original investment ($2401)
    • 10% -> 7% is more than 3X the original investment ($3289)

Compounding Frequency the Least Significant Factor

The final factor is how frequently the earned interest starts earning interest.  Let’s look at the example of 20 years with a 10 % interest rate again, but compound it with different frequencies:

  • More frequent is always better but the effect diminishes rapidly
  • Never to yearly is a big difference
    • More than 3X original investment($3,727)
  • Yearly to quarterly is much smaller but significant difference
    • Not quite half the original investment ($482)
  •  Quarterly to Monthly even smaller
    • About a tenth of the original investment ($118.5)
    • This is at about 99% of compounding instantly
  • Monthly to Weekly still smaller increase
    • May buy you a dinner ($46)

I hope you found that you learned something,  I plan to follow up with a post onpractical investment lessons soon.   Unclear about something, Liked it, hated it?   Leave a comment, just be thoughtful.

2 Responses to “You Need to Understand Compound Interest”

  1. Jack Johnson says:

    I understand the numerous benefits of compounding interest, but how do I apply this concept to my Roth IRA? I am currently invested in mutual funds, but I don’t quite understand how / what investments would yield a 10% return through interest.

    Thanks!
    Jack

  2. Rick Francis says:

    Jack,

    > How / what investments would yield a 10% return through interest.

    Stock index funds can have 20 or 30 year averages in the 8-10% range but they are anything but steady and by no means guaranteed. Here is a page that lets you calculate returns on the S&P500 for different periods: http://www.moneychimp.com/features/market_cagr.htm

    In practice paying off debt is the only certain way to get that high of a return.

    >How do I apply this concept to my Roth IRA?

    Don’t get too fixated on getting a specific return rate- that is something you generally can’t control unless you can save enough money that you can take the much lower guaranteed rates of return.

    But here are some things I keep in mind for My Roth IRA:

    Time is important make those investments as soon as you can.
    Max the contributions if at all possible- it could make a huge difference in the quality of your retirement.

    Taking a moderate risk to invest in stock index funds is likely to really pay off big.

    Minimize fees- a 1% expense is really large! Even if you can’t control the market returns you can choose lower fee funds.

    -Rick

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