Compound Interest: The Magical Formula To Real Wealth

In life there are two types of wealth.  There is physical wealth as in money, and true wealth as in the richness of life. In living, all of us have to make a buck to survive. In this post, I’m going to discuss the power of making that buck work for you by learning a financial secret…the formula of compound interest. Many people who are wealthy, financially, have always know this trick and now I’m going to share it with you.

Ok, let’s get to it…

The Basics

It’s not that hard to figure out why investing is important.  Each of us has hopes and dreams for the future, and any number of them require some sort of financial backing.  Whether it’s being able to eventually afford to buy a house, sending children off to college, or just having enough money to pay for medications in our old age; there are plenty of reasons to start investing now.

Let’s take a look at some numbers…

Long-term investing usually means putting money away for more than five years.  Less than ten years really isn’t all that long-term, either.  The reason that the duration of the investment is so important is because of compound interest.  I know that this is probably really elementary for most of us, but it doesn’t hurt to review the facts.

Some aspects of investing can make you go “duh,” while others are not so obvious.  For example, did you know that the average rate of growth in the stock market has been about 11% over the last 100 years?  That doesn’t mean that money put into the market will automatically gain 11% each year.  Some years it might gain more, and some years it might even decline.  The current state of the economy is certainly proof of that.  The point here is that over a long period of time, one can generally anticipate about an 11% annual return on investments.

What Does It Really Mean?

11% doesn’t necessarily seem like all that much, until you start figuring in how it compounds.  Let’s say that you start with $1,000.  By the end of the first year, that amount will theoretically be worth $1,110.  The next year, you are earning your interest on that total, so you would add 11% to your $1,110 for a total of $1,232.10.  Each year, the previous year’s total is growing, so the amount of your interest also grows.  The numbers are compounding!

Consider this:

•    A one-time $1,000 investment in 2009 would grow to $2,839 by 2019.
•    By 2029, it would have grown to $8,062.
•    By 2039, that same $1,000 would have grown to $22,892.

That little bit of information right there is enough to make a person want to scrimp and save $1,000!  Keep in mind, that this is without even adding to your original investment.  What if you could find a way to add $1,000 each year?

•    By 2019, you would have contributed $10,000, but with interest, it would be worth $17,000.
•    By 2029, you would have contributed $20,000, but with interest, it would be worth $65,000.
•    By 2039, you would have contributed $30,000, but with interest, it would be worth $201,290.
•    For those who are able to start really early and do this for 50 years, the payoff is about $1.7 million.

Does that make your wheels spin?  It sure gets me to thinking.  One thousand dollars is a lot of money, especially on the budget many of us need to keep right now; but I find myself thinking about ways to raise it.  Don’t be afraid to get unconventional.  Young people might consider it in terms of 100 hours of babysitting or yard work for the neighbors.  Maybe it means selling off some of the stuff stacked up in the basement.  Maybe it means just tightening our belts and cutting a few more items out of the budget.

“The most powerful force in the universe is compound interest.” – Albert Einstein -

Making It Easier
Of course, there is a lot of math involved when we get to talking about money.  The concept of compound interest can make things that much more complicated.  Because of the marvelous advance we call the Internet, we no longer have to sit down and create extensive charts and diagrams to figure out what our investments may potentially be worth.  Instead, we can turn to the various online calculators that are set up to do the work for us.  For example, the calculator at MoneyChimp.com allows you to account for your initial investment, the amount you’ll be adding, the number of years you expect to allow it to grow, and several other factors such as the actual expected interest rate.
DaveRamsey.com has another great investment calculator that doesn’t just spit out numbers.  It will create graphs and charts for you and even allows you to print them out.  Not only that, but it helps you see what a difference you can make by giving up certain luxuries, like ordering out, and adding that money to your investment portfolio.  It’s really eye-opening.

“The Rule of 72″
In our scenario above describing how compound interest works, we used the example of 11% annual growth because that’s the 100-year average for the U.S. stock market.  Of course, different investments accrue interest at different rates.  Your checking account probably doesn’t pay you any interest, while a five-year CD might pay five percent or less.

By knowing the percentage rate, you can figure out how long it will take you to double your investment.  The Rule of 72 says that if you divide the number 72 by the interest rate, you will get the number of years it will take to double your money.

•    If your savings account pays 3%  interest, it will take 24 years to double your initial investment.
•    A money-market account or CD paying 5% would take almost 14.5 years.
•    A stock portfolio earning 11% would take 6.5 years to double the initial investment.

An extra $200,000 at retirement time sure seems like it would come in handy, doesn’t it?  If the idea of saving it up seems too daunting, keep in mind that even a little bit can go a long way when you’re harnessing the power of compound interest.  If you only invested $100 a year, you would contribute $3,000 by 2039, and it would be worth more than $20,000.

If you’re a more auditory/visual learner, then you might want to supplement this primer by checking out this video called “Saving Money in Plain English.”

Posted on July 9, 2009