Interest rates are the guiding compass for savvy financial decision-making. The compound effects of interest rates can yield outsized influence over one’s wealth. Understanding the ins and outs of compound interest can be the difference between a comfortable retirement and significant financial struggle.
If you feel like finance is elusively complicated, you’re not alone. It’s what makes most folks reluctant to start on a path toward financial health -- like avoiding a visit to the dentist until we start feeling the presence of that neglected cavity.
But, it's really not that hard! And now with the ever-so-wonderful Google Sheets to do all the calcs for us, access to easy, financial tools is the best it's ever been.
The reality is, interest rates play a pivotal role in every financial decision we make from the minute we open a savings account to the day we retire. No better time than now for a quick course on interest rates, so we can start becoming smarter now instead of punting these decisions and missing out on streams of substantial profits.
An interest rate is the price paid for borrowing money, expressed as a percentage of the loan amount or principal. For lenders or investors, it represents the return on investment for parting with their money, while for borrowers, it's the cost of accessing funds to finance purchases or investments.
The interest rate is charged on top of the principal as a percentage of that principal or loan balance.
Many people are familiar with simple interest, which pays you a set percentage of your principal at regular intervals. It’s often used for more straightforward financial products, such as short-term loans. Simple interest is calculated on the initial amount of a loan or deposit. It’s a basic calculation:
Simple interest = principal x interest rate x number of periods
Let’s say you deposit $10,000 in a simple savings account with a 4% interest rate. After 30 years, you would have earned $8,000 on that initial $10,000 investment:
$10,000 x 0.04 x 30 = $12,000
Compound interest refers to the interest calculated on the initial principal, plus all of the accumulated interest from previous periods. When you invest your money, you earn interest not just on your initial investment but also on the interest that investment has already produced. This compounding effect is what sets compound interest apart, making it a powerful force for long-term growth.
Let’s start with the same example as above, but now let’s say the savings account is compounded annually. The interest earned on the account each year would be:
Year 1: $10,000 x 0.04 = $400
Year 2: ($10,400 x 0.04) = $416
Year 3: ($10,816 x 0.04) = $432
And so forth…
When you sum up the interest over 30 years, the interest alone grows to $23,434. Your total savings account is $33,434 if you include the initial principal depost.
We see that compounding interest annually gives us nearly 2X the return as simple interest on a single $10,000 investment.
The formula for compound interest is:
Compound interest = P x [(1 - r)^n -P]
where P = principal, r = interest rate per period, and n = number of periods.
If you're using Excel or Google Sheets, you would use the FV function:
Compound interest = FV(r, n, 0, P, [end_or_beginning])
where you depositing at the end of the period would be 1 and beginning of the period would be 0.
To get the most out of compound interest, there are three strategies:
In both examples I walked through, I did not remove any cash from our savings account. Why? I wanted to illustrate the point that reinvesting the interest is what drives the snowball effect. Rather than taking earnings out as cash payments, you can keep the earnings there to benefit from compound growth or invest some of it in other types of assets, which may offer better, but perhaps riskier, returns to perpetuate the cycle of compounding. It depends on your own appetite for risk and reward.
The longer the time frame, the greater the benefits of compound interest. This is why starting early is often touted as one of the best practices for wealth accumulation. Even if your contributions are small, the time ahead allows the compounding to do its work.
Side note: Kim has been doing this since she was 16 years old; my nephews (10 and 12) each have their own small investment accounts; and I just created one for my four year old. It's a great, real-world way of showing kids the power of compound interest and eventually different investment and savings strategies, while teaching them about financial health and helping them build their own wealth from early on. We definitely recommend this practice for parents and kids.
By consistently putting money into your investment, you increase the principal amount that is subject to compounding, thus accelerating your returns. Setting aside cash on a scheduled and regular basis can also create more financial discipline by restricting your discretionary spend, or the non-essential expenses like dining out, shopping other entertainment.
Let's go back to our savings account example, but now add in monthly contributions.
We fund a savings account with $10,000, plus we add monthly contributions of $100 per month. This savings account also compounds interest monthly.
We end up having a schedule that looks like this in Year 1:
Fast forward 30 years, and you would have earned interest in the amount of of $56,540.
That’s a 130% increase over the scenario where we only funded with the one-time payment at the start of the account.
Comparing the different scenarios, here’s what your balance would be in each example:
The table above illustrates how utilizing the three strategies -- invest long-term, reinvest earnings, and contribute regularly -- help us maximize our returns with compound interest. The above assumptions also start with a modest amount of only $10,000 at T=0 and $100 per month thereafter. Imagine how much more net-worth you'd have if you could set aside even more toward investing?
The implications of compound interest are profound and far-reaching. It is a powerful tool that can be harnessed by anyone who wishes to build a better financial future. All that is required is an understanding of the mechanics and a commitment to regular saving and investment.
If there is one key takeaway from this article, it is this: the earlier you start to utilize compound interest, the greater the chances of financial success. Cultivate a habit of saving, invest for the long term, and compound interest will work its magic. In the marathon that is personal finance, compound interest is your steady, reliable pace-setter, taking you closer to the finish line with each and every step.
DISCLAIMER: Information on this site is for educational purposes only. LeHerring LLC does not provide, legal, accounting, tax or investment advice. Although care has been taken in preparing the information provided to you, we are not responsible for any errors or omissions, and we accept no liability whatsoever for any loss or damage you may incur. Always seek financial and/or legal counsel relating to your specific circumstances as needed for any and all questions and concerns you now have or may have in the future.
We cannot guarantee your success, nor are we responsible for any of your actions. Our role is to support and assist you in reaching your own goals, but your success depends primarily on your own effort, motivation, commitment, and follow-through. We cannot predict, and we do not guarantee, that you will attain a particular result.
AFFILIATES: From time to time, we may promote, affiliate with, or partner with other individuals or businesses whose programs, products, and services align with ours. In the spirit of transparency, we want you to be aware that there may be instances when we promote, market, share or sell programs, products, or services for other partners. In exchange, we may receive financial compensation or other rewards.