How Does Compound Interest Work?

Compound interest is often cheekily referred to as the “8th wonder of the world”. While that may be a wee bit of an exaggeration, that doesn’t mean it isn’t one of the most powerful systems in financing.

This simple little idea allows for anyone to invest a small bit of money and get a huge return. All it requires is two ingredients, a dash of money and a heaping dose of time. 

What is compound interest

Here’s the boring technical definition. Compound interest builds on the principle (that’s the amount) of your investment, plus the interest you’ve accumulated over time. Think of it as earning interest on top of interest. This “multiplying” of interest leads to unimaginable growth over long periods of time.

To make a long story short when your investment makes money, you’re making even more money. Who doesn’t love that?

Compound interest + time = money

Ever hear the phrase, “Patience is a virtue”? Well, when it comes to compound interest, patience is a big fat sack of cash.

Compound interest hinges one single key element, time. You’re not gonna build a fortune in one day, but the earlier you start investing, the faster and larger your reward will grow. This is why retirement accounts are such a powerful tool, you don’t need a large sum of money to make your investments worthwhile. All you need is a small trickle over a long period of time.

Basically, it’s the investment version of playing the waiting game, but there’s no losing.

Illustration of compound interest showing money bags rolling down a hill growing larger, like a snowball

Think of compound interest like rolling a snowball down from the top of a mountain. It will start out rolling slowly, gaining small amounts as it tumbles along. Over the course of decades, your snowball will grow into a torrential avalanche of sweet, sweet money.

How compound interest works

Big investments and lots of money sounds great and all, but how exactly does compound interest build like this? Let’s look at an example involving adorable bunnies.

illustration of bunnies multiplying to show how compound interest works.

In this graph we can easily see the amazing effects of compound rabbit orgies, er, interest. Just like those promiscuous bunnies, your money can grow from a small handful, into millions, all from just a little bit of waiting.

“Normal” vs Compounding Interest

To really appreciate the beauty of compound interest, we need something to compare it to. Let’s see how it differs from regular old plain interest. Now, I know what you’re thinking “oh no, not more bunnies”. Fear not, we have exciting numbers to look at instead.

Let’s say you have $1000 in your retirement account, with an interest rate of 8%.

With fixed interest, you would get $80 added to your account every year (8% of $1000). In 1 year, your account would have gotten $80 with a total balance of $1080. After 10 years? $1800. After 30 years, you would have a total of $2400. That’s pretty sad.

Here’s where compound interest works its magic.

With that same investment, in 1 year, you would have the same $1080. By year 10, you’re looking at $2159. What is it by 30? $10,063. Almost 4 times the amount! And that’s not even taking into account contributions that you make. Decide to put an extra $100 in every month? You’re looking at $151,824 by year 30.

illustration of a graph showing how compound interest grows more money over time, compared to regular interest.

Why stop there? Let’s make it even more impressive (the same thing I tell myself when eating Thanksgiving dinner). Let’s say our max contribution + employer matching is $520 a month. In 30 years your account would be over $740,000. That’s what I would call a sweet deal.

Having trouble putting money aside for retirement? We suggest getting started with the basics first and learn how to make a budget. Hey, don’t run away! It’s not that bad!

Start investing now

When it comes to retirement, it’s never too early (or too late) to begin saving. I know, I know, there’s always pressing things we want now, like a shiny new TV or tasty Cinna-Bun. But by starting early, even if it it’s just a little bit, you will set yourself further ahead than putting it off for when you’re “financially ready” to invest. Now stop thinking about Cinna-Buns, and start thinking of your future!

Let’s take a look at an example to put it into perspective, shall we?

Meet Tom and Bob. These two fella’s are looking to retire at 60 years old. But how are they going to get there? 

Tom’s got a level head, and he’s thinking about his future. He’s taking the safe route and started investing $250 a month at age 20. 

As for Bob, his plan is to start investing after he’s 30, once he’s gotten a cushy job. Instead of saving early, he’s out buying a new TV and some delicious Cinna-buns.

Who do you think has more money at retirement? Even though Tom was contributing less, because he started earlier he will have made more money than Bob, and contributed less. 

That’s the magic of compound interest.

Three easy ways to calculate compound interest

Want to know how long it will take for compound interest to double, triple or quadruple your investment?

Of course you do! Here’s how:

All you have to do is take the number of one of these rules and divide by the number of your interest rate (just the number, not the percent). 

Let’s say your interest rate is 5%.

The Rule of 72 – Use this to find how long it will take to double your investment. (72 / 5 = 14.4) That means your investment will double in 14.4 years!

The Rule of 115 – Use 115 to find how long it’ll take to triple! (115 / 5 = 23) That’s 23 years to triple what you’ve got.

The Rule of 144 – Last but not least, use 144 to see how long it will take to quadruple your returns. (144 / 5 = 28.8) Just 28.8 years and you’ll see 4 times your initial investment!

Better yet, use an online calculator, like this one!

TL;DR

Compound interest is the amazingly awesome secret of investing. By investing early, you’ll have a clear path to retirement thanks to the power of compound interest.

So, instead of still putting off contributing to your retirement account, add a little extra each month, even if it’s just $25. You’ll be thanking yourself with hundreds of thousands of dollars in the future!

…And probably some warm, gooey Cinna-Buns after reading this.

As you can see, compound interest is awesome, so why wait to invest? Learn everything you need to know about your retirement plan.


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