What Is Compound Interest?

What’s the most powerful force in the universe? A meteor? A black hole? A home run by Mike Trout? According to Albert Einstein, the answer is actually compound interest.

Of course, whether Einstein really said these words is up for debate, but the point is still an important one. Compound interest might not be the most powerful force in the universe, but it’s certainly the most powerful force in finance. Compound interest can be a saver’s best friend or an overspender’s worst enemy, capable of both making and destroying fortunes. Knowing how it works and using it to your advantage is the quickest way to get ahead of the pack when avoiding debt or saving for retirement.

If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.

How Does Compound Interest Work?

When you’re learning a new skill like playing guitar or programming computers, you don’t become an expert overnight. You need to learn the basics, practice your technique, and make incremental moves up the ladder of proficiency. The lessons you previously learned help unlock new aspects of the discipline—your knowledge compounds, so to speak.

Compound interest is the same way. If you deposit money into a savings account, you’ll earn interest on your deposits. As your balance grows, so do the interest payments you receive from your funds. You’re earning interest on the interest you previously earned, that’s why it’s called compound interest. Over time, the interest you earn increases in velocity as your balance grows.

On the opposite end of the spectrum, compound interest can be a negative on your finances. If you owe high interest debt on credit cards or student loans and can’t afford to make your minimum payments, the amount you owe will balloon as the interest compiles on top of previous interest installments.

Examples of Compound Interest

Let’s say you’re opening a 401(k) with a new employer and want to calculate how long it will take for you to earn $1 million. You plan on using basic index funds as a vehicle and earning the returns of the overall market, which tend to average between 6% to 8% annually. We’ll say 7% to have a nice round number.

If you invest the maximum amount in your 401(k) each year (currently $19,500) and compound annually at 7%, it will take 23 years to exceed your goal of $1 million. In this scenario, you’ll have contributed $448,500 over the 23 years and finished with a total balance of $1,042,004.

Here’s the downside of compound interest. If you have credit card debt and carry a balance from month to month, you’ll also feel the effects of compound interest. Let’s say you’ve got a $10,000 balance on a credit card with an APY of 18%. If you only make the minimum monthly payment (ie. $100 per month) over a period of three years, your total debt will be $12,830.32. Yes, despite paying $100 off every month, you’ll owe nearly $3000 more than you did three years ago. That’s why credit card debt is so destructive—if you can only pay the monthly minimum, your debt will become a snowball that’s perpetually picking up speed.

Using Compound Interest to Your Advantage

The Federal Reserve has a simple heuristic for calculating compound interest called the Rule of 72. According to the Rule of 72, you can simply divide the number 72 by the interest rate of your credit card, stock returns, or savings accounts to figure out how long it will take to double your money.

Let’s go back and use the 7% investment return from the previous example. Dividing 72 by 7 gives us 10.3. It’ll take just over 10 years to double an investment that compounds at 7% annually. This $10,000 compounded at 7% over 10 years will result in a final balance of $19,671.

Turning $10,000 into $20,000 over a decade might not sound like much, but compound interest is always working. After another 10 years, your $20,000 will grow to $40,000, and then $40,000 into $80,000 the next decade. And this is if you never contribute anything beyond your initial $10,000.

Now let’s factor in a $1000 monthly contribution on top of the first $10,000. After 10 years, you’ll have over $185,000. Another 10 years? $529,000! Compound interest might not be able to bend gravity like black holes, but it can do something far more useful to the average person: create another wealth to retire in just three decades of saving. The earlier you start saving, the more time you have for compound interest to work its magic, so don’t hesitate to contact your financial advisor and develop a plan to secure your future today.

Work With an Experienced Financial Advisor

If you have any questions about compound interest, reach out to a team member from Good Life Financial Advisors of Mount Pleasant today! We’re happy to assist you.

Disclosure

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.

These are hypothetical examples and are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.