There are a lot of complicated terms thrown around when it comes to budgeting, personal finance, and all things money. It’s tempting to ignore them all. I tried that. It doesn’t work.
So here’s a really simple breakdown of what compound interest is and why it’s important. In just a few minutes, you’ll be saying, “Oh, is that it? It’s so easy!”
What is interest anyway?
Let’s start with interest first. According to Wikipedia:
Interest is payment from a borrower to a lender of an amount above repayment of the principal sum (i.e. the amount borrowed). It is distinct from a fee which the borrower may pay the lender or some third party.
I bet your eyes just glazed over, right? Let’s make it simple. If you borrow money from someone, you’ll pay them extra when you return it. The amount extra is usually a percentage of the original amount. So if you borrow money from a bank, you’ll pay them interest when you return it. Before the borrowing, you agree on an amount. Let’s say it’s 3%. If you borrow $100 then when you pay it back, you’ll add on 3%. Because $100 x 3% = $3, you’ll pay back $103 – the original $100 plus $3 interest.
Are you with me so far? Good!
Now, when you put money into a savings account, you’re basically lending your money to the bank, so they pay you interest on that money. Years ago you might have gotten 3% interest in your savings account. Now it’s more like 0.5%. But it’s still interest. So when you deposit $100 into an account that earns 0.5% interest, you’ll get an extra $0.50 every year. If that account earned 5% interest, you’d get $5 every year.
How compound interest is different
You’re earning interest on your money every year. The question is, are you earning simple interest or compound interest? (Hint: If it’s a savings account or a stock investment you’re earning compound interest.)
Simple interest means you get a certain amount of interest based on the original money you lent. Compound interest means you get interest on the original money and on interest you already earned previously. Don’t worry, this is much simpler than it sounds!
Simple interest: You lend $100 at 10% per year. The first year you earn $10 (because 10% of $100 is $10.) Now you have $110. The second year you earn $10 because you’re still earning interest on the original $100. Now you have $120. The third year you earn $10. Now you have $130.
Compound interest: You lend $100 at 10% per year. The first year you earn $10. Now you have $110. The second year you earn $11 (because 10% of $110 is $11.) Now you have $121. The third year you earn $12.10. Now you have $133.10. You have an extra $3.10 compared to what you would earn with simple interest because with compound interest, your interest also earns interest.
With bigger numbers, and when you continue to contribute/lend more each year, the differences become stark. You can begin to see it in the first few years in the chart above. But check out what happens after a few decades!
When this becomes fun!
Yeah, I said it: compound interest is fun! Why? Because it’s free money! Well ok, there are some risks. If you invest in the stock market you might get 15% interest. Or you might lose money. Still, there are some great potential benefits. And every single person I show my compound interest chart to gets really excited, even if they thought they hated all things finance-related. (Sign up below to get the chart for free and see how your money will grow! For now, check out the small clips from the charts in this post!)
Let’s say you want to start saving for retirement. You do the math and it’s a big number. It’s overwhelming! Well, let’s see how it might work out.
You can sign up to see the full chart, but for now we’ll look at the results. At age 25 you start with $1000. Then you add to it each year. You’re earning 10% interest (not because that’s a guarantee, but because it’s a nice round number for this example; some people average more and some average less.)
Now, let’s say you save $2000 per year. That might sound like a lot, but it’s only $166.67 per month. If you can’t save that yet, it’s a great first goal to aim for. By the time you’re 65, you’ve saved $82,000. But thanks to the magic of compound interest, you’ve got $930,444!
Check out what happens if you increase that to saving $6000 per year ($500 per month) or $12,000 per year ($1000 per month.)
If your jaw just dropped, you’re starting to see the value of compound interest.
Time is your friend
The trick here is that compound interest needs time to do its thing. Because you’re earning interest every year, and it’s growing (compounding) on the interest from previous years, the more years you’ve got, the better. That’s why I wish so much I’d known this when I was in my 20s! Still, starting in my 30s was pretty good too. And you can even start in your 40s or later. But the important thing is to start now. Don’t wait. Here’s why.
I don’t have room to show you the entire chart (you’ll need to sign up for MTFEC to see the whole thing) but you can see the end result. Basically, in both cases you start with $1000. You save $20,000 total (not including the original $1000) and you earn 10% compound interest.
In the first case, you start saving $2000 per year at the age of 25 and continue for 10 years. That means you stop saving by 35 and just let any increases come from compound interest after that. In the second case, you are only seeing increases in your account from compound interest until you’re 45. Then you start adding $2000 per year for 10 years, and stop at age 54.
You’re contributing the same amount in both scenarios ($20,000) but check out the bottom line: $601,456 vs. $136,202. Why? Because in the second case, compound interest was only building on that $1000 in the early years. When more money was added later, there wasn’t as much time for the compound interest to grow.
Why this matters
My goal with this blog is to set you up for a financially stress-free life, and since you’re reading this, I’m guessing you’d like that too (who wouldn’t?) Part of that is understanding concepts like compound interest and know how to use it to your advantage. You’ve just seen how powerful and lucrative compound interest can be, so now you can start planning how to use it to fund your goals.
What will you do first? Take a moment to look at those charts again. Use them as inspiration! I’ve created a free compound interest calculator that that you can use to make your own version. Just put in the amount of interest you expect to earn and how much you plan to save every year and it’ll show you how much you will have in savings each year. With that knowledge, you can really take control of your savings and make some awesome plans! Use it to figure out how your money is going to work for you. Just enter your email address here to get it. Then please share in the comments or by email how it’s going for you!