“Compound interest is the most powerful force in the universe”

– Albert Einstein

WHAT IS COMPOUND INTEREST?

Fundamentally, compound interest is the process of earning interest on both an initial investment and the accumulated interest over time. This compounding effect allows your money to grow exponentially faster, creating a snowball effect that propels your wealth.

Starting early is the key to maximizing the benefits of compound interest because of the time value of money. Every year counts in the compounding process, giving your investments more time to grow and multiply. Even small contributions, when given time to flourish, can have a significant impact on your long-term financial well-being.

Key Variables:

When it comes to compound interest, there are several key variables that influence its growth and impact. Understanding these variables is essential for maximizing the power of compounding.

• Principal: The principal refers to the initial amount of money invested or borrowed. It is the starting point from which compound interest begins to accumulate.
• Interest Rate: The interest rate is the percentage at which the invested or borrowed amount grows over time. It determines the rate at which compound interest is added to the principal. A higher interest rate leads to faster growth, while a lower interest rate results in slower growth
• Compounding Period: The compounding period is the frequency at which the interest is added to the principal. It can be annually, semi-annually, quarterly, monthly, or even daily. The more frequent the compounding, the more interest is added, resulting in faster growth.
• Time: Time plays a crucial role in compound interest. The longer the investment or debt remains untouched, the greater the compounding effect. The more time you give for the interest to accumulate, the larger the final amount will be.
• Contributions or Payments: For investments, additional contributions made over time can significantly enhance the growth of compound interest. Regularly adding money to the investment allows for a higher principal and more opportunities for compounding. On the other hand, for debts, regular payments reduce the principal and limit the negative impact of compound interest.
• Inflation: Inflation is the general increase in prices over time. It erodes the purchasing power of money. When calculating compound interest, it is essential to consider the effects of inflation on the real rate of return. Adjusting for inflation provides a more accurate understanding of the actual growth or cost of an investment or debt.

Example:

Let’s say you invest $1,000 in a savings account that pays an annual interest rate of 5%. After one year, you will have earned $50 in interest, bringing your total savings to $1,050. In the second year, you will earn 5% interest on the new balance of $1,050, which would be $52.50, bringing your total savings to $1,102.50. In the third year, you will earn 5% interest on the new balance of $1,102.50, which would be $55.13, bringing your total savings to $1,157.63. This cycle continues, and the interest earned each year is added to the principal amount, resulting in exponential growth of the investment.

The Importance of Starting Early:

Imagine we have two hypothetical savers, Emily and Dave. At age 25, Emily puts $1,000 into a retirement savings account with an estimated 5% rate of return. 10 years later, at age 35, Dave chooses to do the same.

Moving forward, Emily and Dave will continue to add $200 per month until they retire at age 65. At that point, Emily will have contributed $97,000 while Dave will have contributed $73,000.

By the time they retire, Emily has almost double the amount of savings as Dave even though she began saving just 10 years prior to him.

Emily – Age 65: $296,959
Dave – Age 65: $163,775