Compound Interest - How to Make Your Money Work for You!

Posted by Maneesh Sethi :: August 2, 2007 @ 8:34 am

Compound interest is the reason why it’s a lot easier to stay rich than it is to become rich---the more money you have, the more money you make. What is compound interest? When you own a loan portfolio or a CD or have money in a savings account, you start with an initial investment amount that is called your principal. You then earn interest on that principal every period (which can be daily, monthly, quarterly, and so on). In the following period, your interest gets compounded (that is good…) when you earn interest on your new principal (which now includes the interest in the previous period).

For example, if you leave 100 dollars in an account that has annual 1% interest, you will make 1 dollar on your 100 dollars (called the principal) in 1 year. Thus, at the end of one year, your principal balance will be $101.00 because it now includes your interest from the previous period. The question is, how much money will you have the year after? If you thought $102.00, you’re wrong---the answer is $102.01. That extra penny came from compounding. That is, in the second year, you earned 1% on $101 dollars, not just $100.

“So what,” you’re thinking. “I made an extra penny.” Yeah, that’s because you shouldn’t be investing money in an account that gives you only 1% interest. And you shouldn’t be investing for only 2 years. And you definitely should be investing more than 100 bucks.

So let’s fix these variables, and see how much we could make. Let’s say I put $2,000 into an index fund that earns 10% (the average return of the market from 1926-2000 was 10.70.) Then I put it into my handy dandy compound interest equation, and I see how much money I will make over 45 years (when I’m just about 65 years old). How much do you think it is? Maybe $5,000? $10,000? Try again. The answer is $145,780.97.

Compound interest is incredible. Every few dollars you put in today becomes hundreds in a few decades. Compound interest is the reason you should invest early. What happens if I waited 5 years to invest rather than doing so today? I’d only have $90,518.51. That’s right. I lost $55,000 because I invested 5 years too late. Invest early. Invest today. Once you start investing, your money will do all the work for you. Want to be rich? Invest the extra money you have today, and don’t touch it until you’re 65. Put it in an IRA and wait for it to mature. Make your retirement comfortable.

In future articles, I’ll talk about how to invest in IRAs and how to use the “rule of 72” to help you figure out how much money compound interest can make you.

Special Note: these figures don’t take into account inflation. Inflation is usually around 3%, and if you want to account for inflation, subtract 3% from the interest rate. Thus, 10% becomes 7%, and so on. Using 7% over 45 years, $2,000 becomes 29,948.92---not quite as much, but way better than $2,000.

Also, for a last note, here is one really fun calculation I learned from Futurama. In the show, Fry had $0.93 cents in his bank account which gave him 2.25% interest for 1,000 years. Guess how much 93 cents became? 4.3 billion dollars. Save a couple bucks for your great-great-great-great-great-great-great grandchildren…make them uber-rich!