The Power of Compound Interest

I’m going to take a leap of faith here and guess that you would like your money to work for you. 

Well, compound interest does exactly that. The power of compound interest allows you to earn interest on both your initial principal and on the interest that your money earns over time, assuming you don’t withdraw the money. 

Picture this.

Say you start with $10,000 earning 10% compound interest per year. At the end of the year, you will have $1,000 from interest. And because you are good about your finances (wink wink) and are trying to grow your investments over the long-term (WINK ), you leave the $1000 in the account along with the original $10,000, totaling $11,000. In the second year, you will have a $1,100 interest, on the $11,000. And so on. In 30 years, you will have a whopping $198,439!

Boom! See how that works? This, friends, is the power of compound interest.

Ready? Let's dive in and learn more about what makes compound interest so powerful, how compound interest can work for you - and how it can harm you.  

Why is compound interest preferable to simple interest

Unlike simple interest which is only calculated on the principal amount, compound interest, as mentioned above, can be thought of as “interest on interest” which results in your money growing at a faster exponential rate.

Let’s take a look at another example.

Say you invested $10,000 at 10% annual interest in 2 different accounts. Here is how the account earning simple interest will compare to the compound interest account after a 30 year period. 

What makes compound interest powerful?

30-year performance of $10,000 investment compounded annually. Source: Nerdwallet

The power of compound interest can make a world of difference in your investment portfolio.

You might be wondering what then factors into how your account could perform. Here's what you should keep in mind. 

1. Time

Compounding is more dramatic with the length of time that the investment is allowed to grow. Even relatively small investments made early in life can have the ability to compound into huge sums of money. That is how teens can become millionaires! With time on their side. 

So start early. I cannot emphasize this enough. Start with whatever you have and forget about it until much later. 

2. Interest rate

You might have guessed it already, but a higher interest rate will lead to faster growth in your account. 

However, before deciding to invest in investments promising the highest interest rates, you’ll need to first assess your personal risk tolerance. This is because investments with high returns are associated with higher risk. 

3. Deposits and Withdrawals

The amount deposited into the account will have an impact on the growth of your account as you might have imagined, but so will withdrawals.  

Withdrawals dampen the effect of compounding. Let your money grow, and give it regular boosts by adding new deposits whenever you can. 

The National Study of Millionaires by Dave Ramsey found that three out of four millionaires (75%) said that regular, consistent investing over a long period of time was the reason for their success. 

“Successful investors typically build wealth systematically through regular investments, such as payroll deductions at work or automatic deductions from a checking or savings account,” says Jess Emery, a spokesperson for Vanguard Funds.

4. Frequency 

The frequency of compounding matters. More frequent compounding periods—daily, for example—have better results. This is something to look out for when opening a savings account - you want those accounts that calculate interest daily as opposed to monthly or annually.

When compound interest hurts you

Adulting is sort of a mixed bag, wouldn't you agree?

You find this absolutely fabulous thing called compound interest which can be your best friend when you are investing, but learn that it can also be your worst enemy when in debt?

What’s up with that? Here's when compound interest can harm your finances.

1. When you have high-interest debt

Well, sadly, compounding interest also applies to debt. If your debt is subject to compounding interest, the balance can grow uncontrollably without intervention. See, compounding interest works for the lender when you’re in debt. 

Missing loan payments or falling behind can have serious effects. To counter the negative effects of compound interest, you should pay off your debt as quickly as possible. You can also look into refinancing your loans to a lower interest rate.

If you have credit card debt, you’re not alone. At a staggering $5313, the average person's credit card debt in the U.S. paints a clear picture. But you should attack that monster with all that you’ve got as fast as you can to keep compounding interest at bay.

I won't lie and say that it's easy, it's not. If it was, then no one would be borrowing. It will be hard, but you can do it, and you’ll be all the much better for it.  

2. When you tap into your tax-deferred accounts

When you take an early withdrawal from your tax-deferred accounts, not only will you pay a 10% penalty, but you're also giving up the ability of those dollars to compound over time. This really adds up!

3. When you have excess expenses within your portfolio

Ah, the crafty hidden monster - fees! 

Excessive investment fees - particularly expense ratios - can quickly erode your investment returns.

Expense ratios are expressed as a percentage of your investment. They can substantially lower your portfolio returns. In fact, high fees such as a 2% fee could add up to hundreds of thousands of dollars over the course of your investing career. 

I’m not sure about you, but I would rather have an additional hundreds of thousands of dollars in my portfolio. Definitely something to keep in mind when looking into investment opportunities.

Related: Investing guide for beginners

Final Thoughts

As you can see, the power of compound interest is key to wealth building, especially if you have a long-term investment mindset. I’ll have to agree with Einstein on this one - the 8th wonder of the world! 

So there it is! Are you ready to start benefiting from the power of compound interest?