COMPOUND INTEREST 

Compounding has been called the eighth wonder of the world because of the amazing way it can grow small sums into your wealth. In addition to earning returns on the money you invest; you earn returns on any interest or returns at the end of every compounding period. 

Compounding periods can be daily, monthly, quarterly or annually.  You boost the compounded growth of your money by saving more, letting your money grow for longer periods, and seeking higher rates by shopping around for better investments.

Compounding is why you do not have to save $1 million to become a millionaire! You will see some examples on that below.

THE MATH

This is the formula to calculate your final amount using compound interest.  I suggest you simply use any Compound Interest, free app. 

TWO EXAMPLES SHOWING THE POWER OF COMPOUNDING

Jessica, a 25 year old, recent graduate of University Illinois, is frugal and saved $5,000.  As a result, Jessica invests that $5,000 in the Vanguard S&P 500 ETF – VOO.  Each year on her birthday, Jessica deposits an additional $2,500 until the age 65.  

Newman, a 25 year old, graduated from Virginia Tech University the same year as Jessica.  However, Newman is not a good saver and spends his money on new cars very nice vacations and STUFF.  At the age of 35 Newman decides he needs to start saving.  He invests $10,000 in the Vanguard S&P 500 ETF –VOO. Each year on his birthday, Newman, invest an additional $5,000 until the age of 65.

Jessica’s Initial Investment: $2,500

Annual Contributions of $2500 for 40 years = $100,000

Jessica’s TOTAL SAVINGS DEPOSITED: $102,500

Newman’s Initial Investment: $5,000

Annual Contributions of $5,000 for 30 years = $150,000

Newman’s’ TOTAL SAVINGS DEPOSITED: $155,000

WHICH ONE ACCUMULATES GREATER WEALTH, AT THE AGE OF 65? NEWMAN OR JESSICA? 

Jessica achieves greater wealth although Newman saved more money, {$150,000 compared to Jessica’s $100,000}. But due to the power of compounding and her 10-year head start, Jessica accumulates greater net-worth. 

The lesson – START TODAY!

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MORE EXAMPLES SHOWING THE POWER OF COMPOUNDING

Let’s look at the power of compounding on $10,000.  You place $10,000 in your investment account for 30 years and NEVER add another dollar. Assuming eight percent return you will have $109,357.30, at the end of 30 years.  Your interest due to compounding: $99,357.30

EXAMPLE #1: PLACE $10,000 IN AN INVESTMENT ACCOUNT FOR 30 YEARS {ASSUME AGE 30 FOR EACH EXAMPLE}

Initial Principal Amount: $10,000

Monthly Deposit: NONE

Period (Month): 360

Annual Interest Rate: 8%

Compound Method: Monthly

Balance at maturity:

Total Principal: $10,000.00

Interest Earned: $99,357.30

Maturity Value: $109,357.30

EXAMPLE #2: TAKE THAT SAME $10,000 AND DEPOSIT AN ADDITIONAL $100 EACH MONTH: 

Initial Principal Amount: $10,000

Monthly Deposit: $100

Period (Month): 360

Annual Interest Rate: 8%

Compound Method: Monthly

Balance at maturity: 

Total Principal: $46,000.00

Interest Earned: $213,386.81

Maturity Value: $259,386.81

EXAMPLE #3: TAKE THAT SAME $10,000 AND DEPOSIT AN ADDITIONAL $500 EACH MONTH

Initial Principal Amount: $10,000

Monthly Deposit: $500

Period (Month): 360

Annual Interest Rate: 8%

Compound Method: Monthly

Balance at maturity: 

Total Principal: $190,000.00

Interest Earned: $669,504.88

Maturity Value: $859,504.89

FINAL EXAMPLE #4:  YOU CONTRIBUTE THE 401K PLAN MAXIMUM MONTHLY AMOUNT

The maximum amount workers can contribute to a 401(k) for 2019 is $19,000. Workers age 50 and older can add an extra $6,000 per year in “catch-up” contributions, bringing their total 401(k) contributions to $25,000.

FOR FIRST 20 YEARS

Initial Principal Amount: $10,000

Monthly Deposit: $1,584.33 {Maximum monthly 401K Plan contribution}

Period (Month): 240

Annual Interest Rate: 8%

Compound Method: Monthly

Balance at maturity: 

Total Principal: $390,239.20

Interest Earned: $598,452.88

Maturity Value: $988,692.09

FOR REMAINING 10 YEARS {Age 50 to 60}

Principal Amount: $988,692.09

Monthly Deposit: $2,083.33 (You can contribute an extra $500 to your 401K starting at age of 50)

Period (Month): 120

Annual Interest Rate: 8%

Compound Method: Monthly

Balance at maturity: 

Total Principal: $1,238,691.69

Interest Earned: $1,339,526.88

Maturity Value: $2,578,218.62

THE EFFECT OF INTEREST RATES

Any starting amount of money can grow into a fortune with a large enough interest rate. 

Would you rather receive $10,000 a day, every day for a month or one penny that doubles each day for a month? Go ahead and decide.

We can do the math on $10,000 paid daily over one month.  First, pick one of seven months with 31 days NOT February with a puny 28 days.  After 31 days your grand total is 31 days x $10,000/day = $310,000.  A very good month. 

Did anyone pick the penny that doubles each day for a month?  Congratulations!   I was amazed when I first saw the below answer.

Thanks to the amazing math of compounding, at the end of one month, the doubling penny will have earned you $10,737,418 compared with $310,000 if you had collected $10,000 per day. The doubling penny earns you 35 times what the $10,000-a-day option does.  Go ahead and do the math if you want. 

Why does the penny example delivers such big results? Doubling your money every day, is a 100% daily interest rate or an annual interest rate of about:

7,515,336,264,876,266,329,246,337,909,725,878,487,602,184,156,506,623,586,263,331,108,903,068,880,366,747,019,083,836,794,831,259,849,702,191,923,100%  And no I cannot begin to tell you how to read that number!

YOUR OBJECTIVE – FIND THE BEST CONSISTENT INTEREST/RETURNS

Savings accounts will compound your money. But because saving accounts pay low interest rates compounding is very slow. The average interest rate on a savings account today is about 0.09%.

Billionaires like Warren Buffett put their money in investments that pay far more than 0.09% over the long run, such as: Businesses, Stocks; Bonds; Real Estate, etc.

The stock market’s long-term average return has been about 10%. Using the rule of 72, at that rate your money should double roughly every seven years. Dividing the number 72 by your interest rate gives you a rough estimate on length of time to double your money.  This is called the “rule of 72.”

Even a slightly higher rate will boost your money’s compounded growth.

CONCLUSION

Warren Buffett – “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”  The sooner you invest your money, the more you will benefit from compound interest. 

So where should you invest? The simplest starting point is to contribute to your employer’s 401K Plan; any tax advantage plans your company offers; or other retirement savings accounts such as a ROTH or Traditional IRA.

Warren Buffett, recommends investing in low cost S&P 500 ETF index funds.  

An S&P 500 Index allows you to own a small piece of many different companies. The S&P 500, includes stocks for the 500 largest U. S. companies including Apple, Google, Exxon Johnson & Johnson, etc.

COMPOUND INTEREST IS THE EASIEST WAY TO DOUBLE OR TRIPLE YOUR MONEY!

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DISCLAIMER

I am a proud nerd (as my beautiful wife and daughter have told me) investment and finance blogger, with a NC State, Chemical Engineering, University Rutgers, MBA and Harvard University, Advanced Management education.  

I started my first business at ~13 years of age. I am a successful investor in equities and real estate and happy to share my personal finance and investment lessons learned with you. However, I am NOT a licensed financial advisor.  Please do not construe my suggestions on this blog, as recommendations for your personal situation.  For individual finance advice please seek your own licensed CPA or financial advisors.