What is compound interest?

“Compound interest is the 8^th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Albert Einstein.

Time can turn a small difference into a sizeable advantage. Saving an extra 10 – 15% of your cash flow per year can be possible without making major sacrifices and can result in a meaningfully different outcome for your future. The magic is time. As an investor, it’s important to understand that time is your most important ally. Starting early and being consistent is key.

Video transcript

When you invest money or put it in a savings account at the bank, you earn interest. There are two basic types of interest: simple and compound. So what’s the difference?

Simple interest

Suppose you have a simple interest rate. You put $1,000 in the bank for five years at a simple interest rate of 5%. You will earn 5% of $1,000 every year — $50. At the end of the five years, you have earned $250. Seems simple.

Compound interest

Now, suppose you have a compound interest rate. You do the exact same thing and save $1,000 for five years. But this time, you use a compound interest rate. After year one, you have earned $50, the same as before. The difference is, in year two, you will now earn interest on $1,050. Your interest for year two will be $52.50. In year three, your nest egg is $1,050 plus $52.50 — $1,102.50 and your interest earned is now $55.13. You do the same for year four and year five. At the end of the five years, you have earned $276.29 — or 10% more than if you had invested at a simple interest rate. That’s where the magic is.

Compound interest in action

Let’s use an example to show how powerful compound interest can be. Anna and Sarah are twin sisters. At 18-years-old, Anna decides to start saving for retirement using compound interest. She starts putting away $1,200 a year at an interest rate of 5% a year. In 10 years, when she’s 28, she runs into financial difficulty and stops. She leaves the money she saved, compounding interest until she retires.

Sarah is not so forward-thinking. When Sarah turns 40, she realizes she better start to put away money for retirement. Like her sister, she puts away $1,200 a year also using a 5% compound interest rate. She does this every year until they both retire at 60 years old.

Anna put away $12,000, and Sarah put away $24,000. Who do you think has more money when they retire? Anna has $75,515 and Sarah will have $41,663. Even more impressive is that if Anna hadn’t stopped contributing the $1,200 a year to her savings, she would have had $170,392 when she retired.

Use the magic of compound interest by starting to save early for retirement.