The Impact of Compound Interest on Your Wealth Growth
Summary: Compound interest can help you maximize your savings, especially if you invest for the long term. But you don’t want interest compounding on your debts.
Albert Einstein considered compound interest to be the eighth wonder of the world. He claimed, “He who understands it, earns it… he who doesn’t… pays it.”
The power of compound interest enables you to grow your money exponentially over time, but it can also cost you. It’s great for your savings and investments, but not so much for your debts. Let’s look into the power of compound interest and how to make it work for you, not against you.
What is compound interest?
Compound interest is interest that accumulates upon itself. When you deposit money into a savings or investment account, that deposit is considered your principal balance. Your principal balance can earn simple interest or compound interest to help you grow your money over time.
With simple interest, you only earn interest on the principal amount in your account. With compound interest, you earn interest on your principal balance, as well as the interest your money has already earned.
Another way to think about compound interest is that it is interest that earns interest. Interest can be compounded daily, monthly, annually, or continuously. The more often interest is compounded, the faster your money grows. This is the power of compound interest.
For example, if you have a principal balance of $10,000 in an investing account that earns 8% annually, then after one year, the amount in your account will be $10,800. You earned $800 in interest. With simple interest, you would earn that same amount, that is $800, every year if you kept the principal balance of your account at $10,000.
However, with compound interest, after the first year, you’ll earn interest on your principal balance of $10,000. But by year three you’ll earn 8% on $11,664, and so on. The growth of your money snowballs as your interest earnings accumulate over the years.
The table below demonstrates how $10,000 can grow over 10 years, earning 8% interest, comparing simple interest versus compound interest.
| $10,000 balance earning 8% | Simple Interest | Compound Interest |
|---|---|---|
| 1 year | $10,800 | $10,800 |
| 2 years | $11,600 | $11,664 |
| 3 years | $12,400 | $12,597.12 |
| 4 years | $13,200 | $13,604.89 |
| 5 years | $14,000 | $14,693.28 |
| 6 years | $14,800 | $15,868.74 |
| 7 years | $15,600 | $17,138.24 |
| 8 years | $16,400 | $18,509.30 |
| 9 years | $17,200 | $19,990 |
| 10 years | $18,000 | $21,589.25 |
How does compound interest help your money grow?
There are three factors that determine how fast the power of compound interest can help your savings grow. These factors are:
- Your principal balance: The more money you start with, the more you will earn. It’s that simple. Adding to your principal balance along the way can also be helpful in increasing your earnings.
- The interest rate: A higher interest rate will give you a better return. You can use the “Rule of 72” to determine how long it will take to double your money at a certain interest rate. You calculate this by dividing 72 by the interest rate, or rate of return. For example, if your investment earns 3% annually, it will take 24 years to double it. Meanwhile, at a 6% return, you can double your money in just 12 years.
- Time: The longer you keep your money in a savings or investment account and let the interest compound upon itself, the more your initial principal balance will grow. You won’t experience the power of compound interest in a year, though. In fact, the impact on your account won’t be significant for the first couple of years. However, if you continue to let your money compound interest for 10 to 30 years, you are more likely to see the benefits. This is a hypothetical example, does not reflect the performance of any specific investment and is for educational purposes. Investing involves risk, consulting a financial advisor can help answer questions.
The U.S. Securities and Exchange Commission provides a handy compound interest calculator that can give you a fair idea of how compound interest can grow your money. Using the previous example of a $10,000 principal balance earning 8% interest annually, if you continued to deposit $1,000 per month into that account, your balance would have grown to $195,428 after ten years.
How long does it take for compound interest to work?
It takes a few years before you see the real impact of compound interest. So, the earlier you start saving or investing, the better. The key is longevity. Investing even a small amount for 30 years or more is likely to earn you a better return than a larger amount for a shorter period of time.
For example, say you start saving money when you are 25 years old. Every month, you put $1,000 into an investment account that earns 8% annually, which is compounded monthly. You keep this same savings plan going for 40 years. By the time you’re 65 years old, your investment account will have grown to more than $3.5 million.
However, if you don’t start saving until you are 45, then when you turn 65 in 20 years, your total savings will be $62,061, with your contribution being $36,150.
What are the disadvantages of compound interest?
The power of compound interest is beneficial when it comes to your savings and investments. However, you don’t want it on your debts like credit cards or student loans. Compounding interest on your credit card can make it harder to pay off when every payment you make goes primarily towards paying the interest that has accumulated.
In conclusion
It’s never too early to think about building your savings, whether that’s to help support your loved ones when they need it or to help prepare for retirement.
Put the power of compound interest to work for you by investing your money and helping it grow so you’re better prepared for the future. At Mutual of Omaha, our trusted advisors can help you protect and plan your financial future.
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