Compound interest has been called the “eighth wonder of the world.” Albert Einstein famously called it “the most powerful force in the universe.” But can you get rich with compound interest?
And Warren Buffet once said, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
But what is compound interest?
Why is it so magical?
And more specifically, can compound interest really make you rich?
What is Compound Interest?
Compound interest is a pretty incredible concept: earn interest on your interest, and watch your money grow exponentially.
The earlier you start saving, the more time your money has to compound on itself, and the bigger your nest egg will be.
Think of it like rolling a snowball down a hill. If your hill is big enough (aka, you have enough time), even a tiny snowball can turn into a gob-smacking avalanche by the time it hits the bottom.
How Does Compound Interest Work?
So, how does compound interest work? Let’s break it down.
When you let someone else use your money, you earn interest on that money. It is a fee that someone pays you for the privilege of using your money. If you deposit money in an interest-bearing account, you’ll earn interest. If you buy a bond, you are lending money to the bond issuer, and they will pay you interest.
With compound interest, you not only earn interest on your original investment but also on the interest that’s accumulated over time.
For Example:
Let’s say you invest $100 at a 10% annual rate of return. After one year, you will have earned $10 in interest, and your total investment will be worth $110.
In Year Two, you will earn 10% on your original $100 investment, plus 10% on the $10 in interest that was earned in Year One. As a result, your total investment will be worth $121 at the end of Year Two.
Each year, your investment grows exponentially because you’re earning interest not only on your original investment but also on your earned interest from previous years.
This can quickly add up. And over time, it’s how compound interest can make you rich.
This is why getting started early is so important. Even a small amount of money can grow to a large sum, thanks to the power of compounding.
Compound Interest vs Simple Interest
So what’s the difference between simple interest and compound interest?
With simple interest, you only earn interest on the principal amount.
With compound interest, you earn interest on both the principal amount and all the interest you’ve already earned (as long as you don’t withdraw it).
Simple interest is mostly used to calculate rates for things like car loans and short-term loans. (You can use this simple interest calculator to see how it works.)
Compound interest is used to calculate the interest you earn on bank accounts, as well as the interest you owe on student loans, credit cards, and personal loans.
Here’s an Example:
Say you put $10,000 in an account and let it grow. According to this chart, this is how much money you’d have over time if your account earned 5% simple interest vs. 5% compound interest.
Account Balance | 5% Simple Interest | 5% Compound Interest |
---|---|---|
Year 1 | $10,500 | $10,500 |
Year 2 | $11,000 | $11,025 |
Year 3 | $11,500 | $11,576 |
Year 4 | $12,000 | $12,155 |
Year 5 | $12,500 | $12,763 |
Year 10 | $15,000 | $16,289 |
Year 20 | $20,000 | $26,533 |
Year 30 | $25,000 | $43,219 |
Year 40 | $30,000 | $70,400 |
In the beginning, earning compound interest doesn’t make that much of a difference. But over the span of several decades, you can end up with heaps more money with compound interest.
Compounding Frequency
Different accounts add your interest to your balance at different intervals, This interval is called compounding frequency. It could be yearly, semi-yearly, monthly, weekly, or even daily.
The more often your interest compounds, the more money you will make. The difference isn’t huge, but every bit counts, so if you’re shopping for accounts, look at the compounding frequency!
Here’s an Example:
Let’s say you started with $5000 and added $200 to your account every month for 30 years. Your interest rate is 5%, compounded annually. At the end of 30 years, you will have contributed $77,000, and your total balance will be $181,062.95.
If you take exactly the same scenario but the interest compounds daily, you’ll contribute the same $77,000, and your balance will be $189, 505.12. You earned another $8,442.17 just on the difference in compounding frequency!
Can Compound Interest Make You Rich?
Well, maybe. Given enough time and enough money to deposit, you can get rich with compound interest, even if you never win the lottery or have a million-dollar salary. This is because, given enough time, your money will start to explode and compound exponentially (kind of like that snowball we mentioned earlier).
For Example:
Let’s say three best friends decide to invest $500 a month. We’ll call them Steve, Robin, and Nancy. (If you can’t tell, we’re fans of Stranger Things .)
The only difference is that they all start saving at different ages. Here’s how their wealth would compound over time:
Steve | Robin | Nancy | |
---|---|---|---|
When they start investing: | Age 45 | Age 35 | Age 25 |
How much they invest per month: | $500 | $500 | $500 |
Average compound interest: | 8% | 8% | 8% |
Total account balance at age 65: | $284,500 | $704,275 | $1,610,540 |
Total contributions: | $120,000 | $180,000 | $240,000 |
Total interest earned: | $164,500 | $524,275 | $1,370,540 |
In this example, Nancy only saves $120k more than Steve over her lifetime. But she ends up with nearly $1.4 million more in retirement… all because she got started earlier.
That’s the power of compounding! And that’s why compound interest is often referred to as the “connector” between savers and millionaires. It really is the key to building long-term wealth and getting rich without needing a ton of money.
Time is the key that unlocks the magic of compound interest.
Here’s Another Way to Look At It:
Nancy saved $240,000. That’s roughly 15% of her total account balance. The other 85%? Purely compound interest.
On the other hand, Steve had to save 42% of his account balance—a much bigger chunk of the pie. He still got 58% of his balance through compound interest, though, which isn’t too shabby.
So even if you’re reading this example thinking, “Yeah.. but I’m already in my 40s! I’ve missed my chance.” Steve’s proof that it’s never too late to start. Earning $164,500 in compound interest is better than earning no compound interest at all, right?
The Reality Check
Getting rich is never quite so easy. In the real world, you won’t get 10% interest or 8% interest, unless you’re buying high-risk junk bonds. You’re not even likely to get 5%. You might get 2% on a high-interest savings account or 3% on a long-term certificate of deposit (CD). Even that could fall if interest rates drop.
That’s going to put a crimp in the getting rich program, especially if you aren’t able to start with a large amount or add large amounts on a regular basis.
Let’s look at the difference a real-world interest rate makes. We’ll assume that you’re starting with $5000 and adding $200 every month.
Account Balance | 5% Compound Interest | 2% Compound Interest |
---|---|---|
Year 1 | $7,711 | $7,523 |
Year 2 | $10,561 | $10,097 |
Year 3 | $13,558 | $12,723 |
Year 4 | $16,707 | $15,402 |
Year 5 | $20,018 | $18,135 |
Year 10 | $39,291 | $32,650 |
Year 20 | $95,770 | $66,416 |
Year 30 | $188,790 | $107,651 |
Year 40 | $341,996 | $158,007 |
Even at 2% interest, you will still have $57,000 more than you put in, which is not so bad. If you had earned 5%, though, you’d have earned almost $241,000 more than you put in!
That’s the difference a few points on the interest can make. It’s also why it’s actually difficult to get rich on the interest rates you will actually earn, even with compound interest.
This is why people turn to higher-risk investments like stocks. If it was really that easy to get rich with compound interest, there would be no reason to look for higher returns in the stock market!
Which Accounts Earn Compound Interest?
As you can see, compound interest is a powerful tool that can help you earn more on your investments. But what accounts actually earn compound interest? Here’s a closer look:
Savings Account
A savings account is a common type of account that allows you to earn interest on your deposited funds. The interest typically compounds daily and gets paid out monthly or quarterly.
Certificate of Deposit
A certificate of deposit (CD) is a type of bank account that offers a fixed rate of interest for a set period of time. The interest is paid out at the end of the term. However, you typically need to leave the money in the account for the entire term to get the full benefit. You can open a CD at a bank or credit union.
Money Market Account
A money market account is a type of account that offers higher interest rates than a savings account but typically has higher minimum balance requirements. The interest compounds daily and gets paid out monthly or quarterly.
Dividend Stocks
Dividend-bearing stocks do not technically pay interest, but dividend payments behave much like compound interest if you reinvest them.
When you reinvest your dividends, you’re essentially reinvesting the money you’ve already earned on your original investment. This can help your dividends compound and grow more quickly over time.
Just remember that a dividend is not an obligation. If the company isn’t making money, the dividend could be cut or even eliminated!
Zero-Coupon Bonds
Lastly, we have zero-coupon bonds. With these types of bonds, you don’t receive periodic interest payments. Instead, the bond’s principal plus accrued interest is paid out at maturity. The interest you earn compounds semi-annually at a specific yield.
Wondering why stocks, ETFs, and other investments aren’t on the list?
Stock market investments don’t technically earn compound interest, despite what you read online. Rather, they’re assets that appreciate in value over time. You can calculate their appreciation based on expected gains, similar to how you’d calculate compound interest. But the two are technically different concepts, which is why we don’t mention them in this article.
Interest is an obligation. When you turn over your money, the party receiving it commits to paying interest. Stocks have no obligation to go up. Markets have always gone up over time, but not all stocks will, and markets can also go down!
The TL;DR
Compound interest is the process of earning interest on interest. This means that the money you save will grow at a faster rate than if it just earned simple interest.
The magic of compound interest is that it can turn a small amount of savings into a large sum of money over time. As a result, it’s often the key to building long-term wealth.
FAQs
How Can I Calculate Compound Interest?
There are a few ways to calculate compound interest. The easiest way is with a compound interest calculator or spreadsheet.
Another way is to use the following formula: A = P(1 + r/n)^nt
Where:
- A = the future value of the investment
- P = the principal amount invested
- r = the annual interest rate
- n = the number of times the money compounds each year
- t = the number of years the money is invested
Is There Compound Interest on Loans?
While compound interest is an incredibly powerful tool for building wealth, it’s important to remember that it works both ways. Compound interest can make you rich, but it can also make you poor!
If you have debt with high interest rates (like credit card debt), compound interest can work against you, magnifying your debt balance over time.
Credit card debt illustrates how well banks understand the power of compound interest.
Earlier, we looked at how your money grows if you’re getting 5% interest, compounded monthly. Now, remember that your credit card balance is likely to carry a rate closer to 20%, compounded daily.
The banks know exactly how it works, and they take full advantage!
That’s why it’s so important to focus on paying down high-interest debt as quickly as possible.
How Long Does it Take to Double Your Money With Compound Interest?
The Rule of 72 is a quick way to estimate how long it will take for an investment to double in value.
To use the rule, simply divide 72 by your expected rate of return.
For example, if you expect your investment to compound at a rate of 4% per year, it will take approximately 18 years for it to double in value (72/4 = 18).
Of course, this is just a rough estimate, and actual results may vary. However, the Rule of 72 is a helpful tool for understanding the power of compound interest.
How Do Millionaires Live Off Interest?
The term “living off interest” means you derive all or most of your income from investments.
The key to this lifestyle is what’s called the “4% rule.” More specifically, this rule stipulates that, on average, an investor can safely withdraw 4% of their portfolio each year without running out of money.
So, for example, if someone has a portfolio worth $1 million, they can theoretically withdraw $40,000 per year and never run out of funds. If they have $5 million, they could withdraw $200,000 a year.
(You can use this rule to calculate your retirement number.) Of course, the actual amount that can be withdrawn may be higher or lower depending on the specific circumstances.
But the 4% rule provides a good general guideline for those looking to retire early and live off interest. And it illustrates how you can get rich with compound interest.
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