Albert Einstein famously called compound interest the 8th wonder of the world. Those are some strong words from a well-regarded genius! So…what is compound interest and why is it one of the “most powerful inventions of human history” (a description that is also attributed to Einstein)?
What is compound interest?
We’ll start with comparing compound interest with simple interest. Let’s say you are going to invest $1,000. In one account you will receive simple interest and in the second account you will receive compound interest. The interest rate is 5% per year. In the simple interest account, you calculate your interest amount on the principal, and each year you get that same amount. With compound interest, the interest amount credited to your account will be slightly more than the year before because the 5% is applied to the year end balance. In addition to the principal amount, the interest you earned in the first year will also make 5% interest in the second year. Your interest earns interest!
Here’s an example
Let’s dig deeper into the example of your $1,000 investment. With simple interest, you will receive $50 each year on your $1,000 investment ($1,000 x 0.05 = $50). With compound interest you will receive 5% each year on the balance at the end of the year. See the chart below for the results. At the end of the first year, both balances look the same – each account has received the 5% interest payment of $50 and ends with $1,050 in the account. At the end of Year 2, we start to see a difference. The simple interest account has earned another $50 ($1,000 x 0.05 = $50) to bring the total balance to $1,100. The account with compounding interest, however, has earned interest on the prior year’s interest. The entire Year 1 balance ($1,050) has earned 5% interest, so the total account balance is $1,102.50, slightly larger than the simple interest balance ($1,050 x 0.05 = $1,102.50).
It doesn’t look like much of an advantage in Year 2 – just $2.50 more – but each year it inches up until in Year 5, the compound interest account has $26.28 more than the simple interest account. Better, but still not a huge difference. However, let time pass and in Year 30, the simple interest account has $2,500, while the compound interest account has $4,321.94, almost 1.73 times the amount of money in the simple interest account. You can see how the benefit of compounding interest and letting your money grow over time produces magic over the long haul. The powers of compound interest have allowed patient investors to grow their money over time, little by little in the beginning and by leaps and bounds in the later years. No wonder Einstein called it one of the most powerful inventions in human history!
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.