What is Compound Interest?

When it comes to calculating interest, the two basic choices are simple and compound. Simple Interest is calculated one time solely as a percentage of the principal sum. As an example, if the principle is $100, and the interest rate is 4%, the value at the end of the interest period (e.g. monthly, quarterly, semi-annually, annually) would be $104 (100 x 1.04).

Compound Interest

Conversely, Compound Interest is calculated not only on the initial principal but also the accumulated interest of prior periods. Here ya go if you’re interested in the math …

Compound Interest Math

The analogy I often use when discussing wealth accumulation is rolling a snowball. A snowball starts with a single flake [savings] and takes a while [time] to grow. However, as the snowball grows in size, with a larger surface area [compound interest], that larger surface area attracts more snow, faster.

Giant Snowball

Perhaps the best way to illustrate the power of compound interest, other than that giant snowball, is through the story of two brothers, twins Ronald and Robert Smith. Imagine that seven years ago, when they were 28 years old, they had a conversation regarding savings and investments.

Ronald noted that he had managed to reduce his debt and was prepared to invest $1,000 a year. Robert noted, regrettably, that he had not been able to reduce his debt and was not in a position to invest any of his income.

Time and Money

Flash forward to 2013 and the twins are now 35 years old. Ronald has been investing $1,000 faithfully during that time, earned 10% annually on his investments and is now sitting on a $10,435.89 portfolio [FIGURE 1].

During the previous seven years, Robert was not able to invest anything. Fortunately however, he is now at the point where he is able and prepared to invest $1,000 annually. While Robert is just now starting to invest, Ronald decides that he is no longer interested in contributing new money to his investment accounts. Not something that I would recommend, but it makes the point, and this story, much more dramatic.

Fortunately however, he does decide to leave the $10,435.89 in his investment portfolio. Over their birthday dinner (filet mignon, rice pilaf, and a nice Merlot) last Tuesday, the twins both expressed a desire to retire at 60 years of age, in 25 years.

Figure 1 - Ronald Smith

FIGURE 1. Ronald Smith: Ages 28 – 35

Summarized, Ronald invested $1,000 a year for seven years, left the resultant $10,435.89 in place, but has decided to stop investing new money for the next 25 years. His total contributions: $7,000. Conversely, Robert did not invest any money during the seven years that his brother did; however, he did start contributing to his retirement accounts at the same time his brother stopped, deciding to faithfully contribute $1,000 annually for the next 25 years. His total contributions: $25,000. Which brother do you believe will have the larger nest-egg when they celebrate their 60th birthday?

As you probably suspected, even though he contributed $18,000 less, Ronald Smith [FIGURE 2] will have a larger nest-egg (+ $4,888.03) than his brother, Robert [FIGURE 3].

Figure 2 - Ronald Smith

FIGURE 2. Ronald Smith: Ages 35 – 60

Figure 3 - Robert Smith

FIGURE 3. Robert Smith: Ages 35 – 60

Final Thoughts

Compound Interest is a powerful force, one that you should use to your advantage by putting your money to work as soon as possible and minimizing fees, an inhibitor to building wealth and preparing for retirement.

A great Compound Interest calculator, my personal favorite, can be found at moneychimp.com.

Blogger-in-Chief here at RetirementSavvy and author of Sin City Greed, Cream City Hustle and RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit.

12 Comments

  1. Compound interest is powerful, that’s for sure! We are at the point where our investment returns are about to start generating more income than the amount we are contributing to our investment accounts. We are excited to be closing in on this threshold as that is when compound interest will really take off!

    • Indeed. Like my snowball analogy, the growth is slow at first, but once you cross that threshold, you start to see phenomenal growth and experience the power of compound interest!

  2. There’s a reason Albert Einstein called it “the most powerful force in the universe.” Great example of the power of compounding. I’ve long felt this needs to be better explained to young folks while they have time to take advantage of it (miss it while you’re young, and it’s gone). I’m passionate about it, and wrote one of my first posts about it (not nearly as eloquently as you!):

    Building Block II: The Most Powerful Force In The Universe

    • Thanks for stopping by, my friend. I’ll have to check out your post.

  3. Nice description James. I love compound interest – when I explained it to one of our younger family members, their mind boggled (in a good way).

    Tristan

    • Yep. Compound interest is a phenomenon that can either work for you – savings and investments – or against you. Debt. Thanks for stopping by and sharing your thoughts, my friend.

  4. A great example of the power of compound interest. It’s something I share often with my teenagers.

    • It is definitely a powerful force … something I share with all the young people I work with. Getting in the habit of saving/investing in your 20s can pay handsome dividends down the road.

  5. The snowball visual is great (as is your explanation of each variable in the formula).

    I see/hear the term “debt snowball” daily, yet I’ve only seen the same analogy applied to wealth accumulation a handful of time. Maybe that’s because more people have debt?

    • “… I’ve only seen the same analogy applied to wealth accumulation a handful of time. Maybe that’s because more people have debt?” That is probably the case. Perhaps we should start championing the term and practice of creating a ‘wealth snowball.’

      • Love the wealth snowball idea! When I just read what Ty wrote, I thought the same thing about the debt snowball! I’ve tried to explain this concept to my 17 year old. It makes sense somewhat to him, but sharing posts that are written differently will make a difference I think. Thanks James!

        • No problem, my friend. Glad you enjoyed it.

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