How Does Compound Interest Work?

February 7, 2020

What is compound interest? Quite simply, compound interest is the principle by which the interest you earn also earns interest, and the interest on that interest makes interest. By repeating itself again and again, this type of interest gets the name, compound interest.

How does compound interest work? Everyone has ideas and plans for what they want to do in retirement, and we all want to get there someday. The biggest question is, how do I build the assets necessary to fund my retirement dreams?

The answer to that question can lead to more:

  • What are my retirement goals?
  • How much money will I need to accomplish these goals?
  • How should I invest my savings?
  • What types of accounts are best for me?

The answers to these questions could be a never-ending list.

Since we can’t answer them all here, you should understand that all answers are unique to each investor. However, one of the most powerful tools we can use to build our retirement income is compound interest.

In the finance field, compound interest has been called the eighth wonder of the world. The great Albert Einstein himself is credited with coining this phrase.

Now let’s explore how this can help you build retirement savings.

The difference between saving and investing is significant. These two retirement tools are not the same thing, but we must do both to give ourselves the best chance to meet our long-term income goals.

Saving is merely setting money aside in a safe place. It is a passive act. A bank checking or savings account is a much better option than under your mattress or buried in the yard. You are not spending your money, and you are setting it aside for a later date when it is needed.

Investing is putting your money to work for you to use your money to earn more money. Investing is buying something with the idea that it will increase in value, like shares of company stock or a mutual fund in your 401(k) plan. These are very well planned and calculated actions. Investing requires some level of risk, and the level of risk is reflected in the return you will potentially receive. It also requires a level of discipline and patience to be done correctly over time.

We must both save and invest to take advantage of the power of compound interest. First, you save to have money to invest. Then you must invest to earn the interest that can compound, or grow, over time.

Using our definition of compound interest, our money makes money over time. If my investment goes up in value, I’ve earned new money or interest. My interest gets reinvested, and over time, my interest starts to make interest of its own — interest on top of interest.

Think of rolling a snowball through the snow. It grows on itself. The farther you roll it, the bigger it gets. Compound interest works similarly. The more time we let our money grow and reinvest, the more it can grow.

As an example: If you lived in Pittsburgh, PA, and invested $5,000 today earning 8% interest in 20 years it will have grown to over $23,000 ($23,305). If this same investment grows for forty years, this $5,000 grows to over $108,000 ($108,622). You would find a Pittsburgh Certified Financial Planner to assist you when following an example like this or find one in your area.  And keep in mind that this is only an example, and your local financial planner cannot guarantee this rate on a return. This example is simply to show you how compound interest can turn this small five-thousand-dollar snowball into a giant snowball.

You make contributions every month to your 401k. These contributions are snowballs that can potentially grow and compound over time. Stay with that same 8% return, if I contribute $200 a month to my 401(k), in twenty years my account is worth over $113,000 ($113,824). Over 40 years of contributing to my 401k, my balance will be over $644,000 ($644,352). Saving $200 a month for forty years would result in $96,000. With the power of compound interest, investing this same amount for 40 years will turn my $96,000 into $644,000.

You can see why the financial world thinks so highly of compound interest. Compound interest is a powerful tool, and time is one of our most valuable assets. You should take advantage of the time that each of us has on this world and put compound interest to work in your retirement accounts.

 

  • Investment Advice offered through Fragasso Financial Advisors, a registered investment advisor.

 

 

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