What is compound interest, anyway?
Interest on investments can be applied in two different ways. Simple interest means you earn interest on your initial investment (called the principal) over time. Compound interest means you earn interest on the initial investment in addition to the interest earned on that principal over time. As you might imagine, the latter is much more powerful because it has the potential to snowball over time.
A common investing adage is that time in the market is more powerful than timing the market. This just means that the more time your investments have to accrue compound interest over time, the more you stand to gain in the long-term. Compound interest is a relatively simple concept, but many people do not fully grasp the impact it can have over years and decades. That’s why compound interest calculators are so helpful. They provide an easy method for visualizing how your investments might grow in the long term.
Compound interest is the secret sauce to the success of many investors, and the reason why financial advisors advocate starting early and creating habits of continuously adding to your investments over time. For many people, utilizing a compound interest calculator for the first time is the light bulb moment that inspires them to start investing in stocks and ETFs.
Let’s take a look at three hypothetical scenarios to demonstrate why investing, and more specifically, compound interest is so powerful when it comes to wealth creation over time.
- Puts away $100 a month at the age of 22 into a standard savings account.
- Continues saving at this cadence for the next 40 years.
- At age 62, this person will have saved $1,200 per year, or $48,000.
- Invests $100 a month into stocks and ETFs, but does not start doing so until age 32.
- Continues investing at this cadence for the next 30 years.
- At age 62, this person will have $121,287.65 assuming an estimated return rate of 7%.
- Invests $100 a month into stocks and ETFs starting at age 22.
- Continues investing at this cadence for the next 40 years.
- At age 62, this person will have $256,331.48 assuming an estimated return rate of 7%.
Please note that while historical data would support this hypothetical scenario, past performance does not guarantee future results.
By starting ten years earlier and leveraging investments versus using a simple savings account, Individual C will have 137% more than Individual B and 72% more than Individual B, assuming a 7% growth rate on their investments. It’s noteworthy that both Individuals B and C are investing the exact same amount monthly with the same rate of return, but with a decade longer in the market, Individual C’s results are far more significant over time.
It’s also noteworthy that the rate of return will depend on the performance of your personal portfolio. Historically, the U.S. stock market has gone up 10% each year, on average (source: NerdWallet). While there will be expected dips and surges over the years, history has demonstrated an upward trend on the whole.
With compound interest, your money does not just have an opportunity to grow over time; it has the opportunity to grow at an increasing rate over time. That’s why financial experts say the best time to start investing is in the past. And since we do not have time machines, the next best case is right now, should your financial situation make it possible.