Compound interest is a powerful yet remarkably simple way to create serious long term wealth. You don’t need any special investing talents or knowledge; just time and a consistent savings habit. Those are the two magic ingredients when it comes to reaping the financial benefits of compound interest.
How compound interest works
Before we dive into how compound interest works, let’s take a look at simple interest so we can compare the two.
Let’s say you deposit $10,000 into a savings account to accrue 4% simple interest per annum for 5 years.
The calculation for simple interest works like this:
$10, 0000 (the principal) x 0.04 (interest rate) x 5 years (period) = $2000
Simple interest is only paid based on the principal amount so after 5 years, your $10,000 will grow to a balance of $12,000.
Compound interest helps your savings grow at a faster rate because you don’t just earn interest on the principal amount, you also earn interest on the interest.
Let’s take a look at how the original deposit of $10,000 would work for compound interest over 5 years.
Compared to the simple interest result, that’s an extra $166.53.
This increase isn’t really a big deal at the 5 year mark but let’s take a look at the compound interest snowball effect for retirement with more time and additional monthly contributions.
A million for retirement with compound interest
Getting started with compound interest as early as possible is the key to long term wealth accumulation. You’ll see with the calculations below that it’s difficult to catch up, even with larger deposits and contributions.
It’s better to start early and put aside regular, smaller contributions than waiting until you’re earning more later in life.
Investors James, Amy and Cameron all hit the 1 million mark at retirement but take note of the difference in total investment vs interest for each.
Although James made the smallest total investment of the three, the amount of interest he earned eclipsed Amy and Cameron.
James started at age 20 through to 65
After 45 years Jame’s account balance is $1,073,808.85. This is made up of:
Amy started at age 30 through to 65
After 35 years Amy’s account balance is $1,000,703.50. This is made up of:
Cameron started at age 40 through to 65
After 25 years Cameron’s account balance is $1,017,635.51. This is made up of:
You can see how getting your money working for you as early as possible pays big dividends. Getting started with compound interest in your early 20’s and the results will play a major role in your long-range financial goals.
The beauty of compound interest as a wealth building tool is its simplicity. You don’t need to be a savvy investor to take advantage of its wealth-generating power. All you need is patience and a commitment to putting savings away regularly.