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.”
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