# Compound Interest – Personal Finance Fundamentals

I grew up hearing my dad say “Most people don’t know how money works.” He is a Certified Financial Planner, and while there were a few drawbacks growing up the son of a financial planner (no Gameboy or frivolous purchases unless we had saved up for them in advance), it also had huge advantages. Hearing that rich people knew something about how money worked that normal people didn’t know was naturally intriguing to me as a youth.

One of the first lessons I learned was what my dad referred to as “the miracle of compound interest.” With compound interest, opposed to simple interest, you earn interest not only on the initial investment (principal), but on the principal plus interest received to date. Because the principal balance increases with each interest payment received, the amount of interest earned each period also increases.. The longer the money is left in the investment to grow, the greater the value of the return each year.

Well, that sounds nice, but isn’t the point of investing to make money? Didn’t we all anticipate the savings to grow? Can you think of anyone who would intentionally invest their money to lose it? To help illustrate the power of compound interest, my dad gave me an example where a college student at age 20 invested \$2,000 at a 6% average rate of return and never touched the money until retirement. He told me that at age 68, the account balance would be \$32,000. As my financial knowledge was still in its infancy when I heard this lesson for the first time, I found it exciting that the initial investment of \$2,000 could grow by \$30,000 over time. I didn’t know how to calculate percent change, but it wasn’t necessary to know this was a 1,500% increase in order to recognize the significance of the growth.

In the next part of the lesson, my dad asked me what I thought would happen to the ending balance if we doubled the interest rate in the example to 12% and left everything else unchanged. I thought to myself, “what an easy question — if the interest rate doubles, the ending balance will double,” and answered that the ending balance would be \$64,000. He told me that this was a good guess and that was what most people would guess, or they might add a little extra for the compounding. However, he said that most people never knew how much extra to add to the \$64,000 to account for the compounding. He said that rarely had anyone ever guessed that the ending balance would be over \$100,000. I thought it was preposterous that he even mentioned the six-figure number; this had to be way too high.

At this point, my dad taught me a simple formula in finance known as The Rule of 72. This formula is used to determine how long it will take for an investment to double at a given interest rate. The formula works by dividing 72 by the rate of return (72/Rate of Return % = Number of years to double). Using this formula, I realized that doubling the interest rate will not double the initial investment, but will cut the time it takes for the investment to double in half.

Returning to the question he had posed, I was astonished to find that the ending balance was not only greater than \$100,000, or even \$200,000, but was over a half a million dollars. I just couldn’t believe it; an investment could grow from \$2,000 to over \$500,000. It’s not like we were talking about letting the investment grow for eternity; on the contrary, I could experience this financial growth in my lifetime.

What this lesson teaches is that to fully maximize the potential returns from compound interest, we need to

1) start saving as early as possible to allow there to be more time for the interest to work its magic and

2) strive to obtain as great a rate of return as possible within our risk tolerance levels.

Compound interest is truly miraculous. Going back to our example one final time, given an additional 6 years at the 12% interest rate, the balance of the account would be worth over one million dollars. There is no question why Albert Einstein called compound interest “the eighth wonder of the world.”

Image courtesy of orangeacid

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### 28 Responses to Compound Interest – Personal Finance Fundamentals

1. alc00b says:

Great article. I can use this expalnation for my own son!

2. Debbie M says:

Disappointing article. It’s true as far as it goes but 1) Earning 12% interest for 48 years really would be a miracle and 2) People never like to mention the anti-miracle of compound inflation. Earning even 6% over inflation for 48 years would be a miracle.

You also don’t mention how the really exciting growth doesn’t happen at the beginning or even the middle. During that time, just adding even a small amount of your own money will usually make a much bigger difference in your final savings than the interest will.

3. ebs02a says:

great article! If the above “critic” were to actually read the article, instead of getting hung up on the numbers, they would have noticed that the main point, as re-stated in closing is to start saving early. Well written article

4. whisper says:

great article and very relevant to a life of integrity! If our future lives like this, our future is exciting!

5. Don Brooke says:

Great article and very well written. I have made it required reading for my all 7 of my grandchildren. I agree with “ebs02a, in that “Debbie M” should read the whole article. I also agreee with the author in that an early savings habit is a very desirable trait.

6. SeattleSmiths says:

Great advice for all young people and families. You can be sure that we will be teaching the rule of 72 in our household. Thanks for the informative article!

7. zelp says:

I have to agree with Debbie here – mediocre article at best. It seems like the author is getting all his friends to try and make this sound like a great article when it’s a average at best. If you want people to compliment the article, write something better.

For all those giving it high praise, what the hell have you been smoking? There are so many better articles on this blog and you focus on this single one as being outstanding? I smell a rat and a campaign to try and make this article seem better than it really is.

8. ebs02a says:

Man we are so busted! How did Zelp know that we have been “campaigning” for 3 years now?! And just waited til this article to start? We have all graduated from 3rd grade zelp, and moved beyond gossip and “clubs”, and onto adult conversations about finance. You were very original with your response “I agree with debbie” sounds like the rat has been spotted. I think the investigative reporter blog you were looking for zelp is at CSI.com, if not, leave responses to the article, not the responses

9. moorem says:

Well written article and simply put for individuals that are not very number savvy! This is great advice that will be put to use.

10. TheKrecks says:

If only others were smart enough to do this! Great article, great advice!

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12. Mark Hamilton says:

Well written & kept simple, the major points were very clear & thought provoking, Einstein was right on the \$ money as it were

13. Steven says:

A brilliant concept, yet so simple. Wish I hadn’t waited until the age of 30 to start thinking about saving and investing.

Wonderfully stated post.

14. Sheryl Hamilton, PhD says:

I am a high school counselor. I am putting a link to this on the school website! Awesome.

15. James says:

Folks,

It’s a basic and unremarkable blog post. The numbers used are indeed misleading.

The author’s fan should save their applause for his better work. He does have better work, right?

16. COURTNEY BROOKE says:

‘TIS TRUE AND TOO BAD MANY (NOT ONLY “THE YOUNG”), DON’T REALIZE THE FACTS. HOW CAN YOU TEACH THEM???

17. Jay Gatsby says:

I’d actually like to know where the author is getting a 6% return year-over-year. These days, you’re lucky if you’re getting anything over 3% in a safe investment that doesn’t require a long-term commitment (e.g., 5-year CD).

18. Gari says:

It sounds like he appreciates the early financial advice his Dad taught him!

19. Gari says:

It sounds like he respects and appreciates the early financial advice his Dad tried to teach him!

20. Mike says:

To all of the negative posters I would ask why you came to this site in the first place? The post was well written and simple to understand. Like myself I knew this rule, but others may not have. In this day and age even 5% is better then what the S&P has dished out (flat lining) for the past 10 years. Take inflation in to account and your losing serious money.

About 7 years ago I settled for a jumbo IRA pulling my money out of the markets. At 5.5% the money is doing something other then losing.

Jay there are many banks paying up to 5.5%. I went to bank rate when I first decided to pull the plug on the market and settled for a bank 3 miles from home which had the best rate at the time.

Debbie you can’t make 6% over inflation with the S&P. 3 to 4% is better then a kick in the rear!

Cash is king and will be for several more years. If people were to save like they did years ago we wouldn’t be in the mess we are in today.

21. IVSPORT says:

I am a new grad from college and just found my first well-paying job. I’m looking to save but don’t know where to find compound interest, especially in the rates you’re mentioning. Thanks to advice from a friend, I started a WaMu savings account with 3.75% APY, which he says is the best I can do. Any ideas on how to do better with the limited savings I will have?

22. Steven says:

@Ivsport

I have half my money in a short term bond fund and half of my money in a money market fund. When money market rates go down, bond rates go up and vice versa. Vanguard and T Rowe Price offer these funds. I make deposits into each account monthly. Good luck

23. SeattleSmiths says:

Steven: Can you explain short term bond funds and possibly give the advantages/disadvantages? I have a money market fund, but need to research your other suggestion further.

24. Steven says:

@SeattleSmiths
A short term bond fund invests in a broad range of corp. debt securities, obligations of the US government, and it’s agencies, with a weighted maturity of 10 years or less. The fund also invests 20-35 per cent in high yield or junk bonds. To my knowledge, there has never been a problem with short term bond funds and they’re considered perfect for “widows and orphans”. Like money market accounts, you can write checks against your fund.

Returns on my money market account: 1year 3.08 3years 3.09 5years 3.43
Returns on my short term bond fund:
1year 6.19 3years 4.48 5years 3.83

As short term instruments, you can see why you should diversify your cash.

And watch the fees and expenses! That’s why I do business with T Rowe Price and Vanguard.

Good luck!

25. gmc says:

Good basic information. It is amazing and frightening to see how many college educated young professionals do not understand the basic concepts of the importance of early investing, determining risks of various investments, returns on investments and fees and loads of various funds/institutions. Our society has been far too tolerant of embracing instant gratification at the expense of fiscal responsibility. Even though one may see fluctuation in returns over years, practicing disciplined savings and investing will certainly make for a brighter and more secure future.

26. Oasdg says:

Saving now is the surest way to keep yourself out of debt in the future! You should always look around and see if you’re getting the best return you can. There are a lot of websites out there that can give a glipse of the going rates->bankrate.com is my personal favorite.

27. VIJAI says:

Jordan,

I really liked the story and moral or lesson learned. I never know the 72 thumb rule and its good one.

Compound Interest is the greatest invention and ever lasting one. No doubt about it.

Vijai

28. Gail says:

No matter the interest rate, the sooner you start saving and leave it in place EARNING THE BEST INTEREST RATE YOU CAN FIND, the more money you will have at the end of the savings period. That is the miracle of compound interest! This is something people need to learn at the beginning of their financial life. That is what these blogs are about and I do not know the author of the article, but I do know he was blessed to have a father teach him about finances at an early age.