The Money Manual FAQ: A Guide To Understanding Compound Interest

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You’ve likely heard people talk about how important compound interest is, or read about its power in a magazine while you were sitting bored at the airport, but you’ve never really understood what it means, and why you should care about it. In this Money Manual FAQ, we are breaking down all of the questions about compound interest you probably have, so you can finally get a grip on why Warren Buffett thinks this is the most powerful tool when it comes to accumulating wealth.

What’s the big deal about compound interest anyway? 

“Compound interest is nothing more than having your interest reinvested into whatever your investment vehicle is,” Barry Zischang, vice president of wealth strategies consultant/estate and high net worth at RBC Wealth Management’s Micera Investment Group told The Street. “Essentially, you’re earning interest on your interest over a period of time. Instead of taking your money out and investing it in something else or spending it somewhere else, you’re plowing it back in and letting it grow on a compounding basis over time.”

Warren Buffet explained it like this in the HBO documentary Becoming Warren Buffett:

It goes back to that story you probably learned in grade school where somebody did something for the king, and the king said, ‘What can I do for you’ and he said, ‘Let’s take a chess board and put a kernel of wheat on the first square and double it on the second and double it on the third.’ The king readily agreed to it and when he figured out what 2 to the 64th amounted to, he was giving away the entire kingdom. It is a pretty simple concept, but over time it accomplishes extraordinary things.

The shorthand version (so you can sound smart at your next dinner party): Compound interest matters because you are not just investing a set sum of money, you are constantly reinvesting your interest and earning money on that money. This allows the money you are earning compound interest on to snowball.

Will it really make that much of a difference to me, I don’t have that much money invested? 

The short answer is yes, but let us explain. Say you invest $1,000 at 8% simple interest. After the first year, you will get paid $80 in interest. The next year, you’ll also get $80, and so on and so forth.

Now, the scenario is different when you are talking about compound interest. We’ll stick to the same amount, and say you start investing $1,000 with 8% compound interest. The first year would be the same, you would receive $80 in interest. This is where the trajectory starts to change. In the second year, you’d earn interest on $1,080, so you’ll be paid $86.40. The following year, you’ll be earning interest on $1,166.40, so you’ll be paid $93.29. Your money is starting to snowball.

In the first scenario, your $1,000 at 8% simple interest would be worth $3,400 after 30 year. If you were earning 8% compound interest though, it would be worth $10,062.66.

OK, but how does this work in the real world?

Most people earn compound interest by investing in the stock market. To give you a sense of how compound interest works in the wild, say you had invested $10,000 in Apple stock on December 31, 1980. That would be worth a staggering $3,595,520.68 today. If you had made that investment you would have received an annual return of 16.75% (based on a Morningstar analysis of the stock).

That foresight certainly would have been nice, because not only has Apple stock steadily risen, but in that scenario you are seriously benefiting from compound interest, because, in a simple interest scenario, using the same 16.75% annual return, your $10,000 investment would be worth just $63,650.

In one scenario you have become a multi-millionaire, and in another, you’ve manged to accumulate just a small nest egg.

So is this why my parents were always on me about ‘starting early?’

Yes, this is exactly why, and thinking about compound interest in reverse gets to the heart of this point. Say that you have a goal in mind of accumulating $1 million by the time you are 60. If you are 45-years-old and hoping to reach that bank balance in fifteen years you would need to invest $3,741.27 each month till you are 60 (assuming 5% compound interest) to reach your goal.

A 35-year-old, by comparison, would need to invest $1,679.23 each month, while a 25-year-old would need to invest $880.21 every month.

The power of compound interest is very much real and can shape your financial future.

Feature Illustration: Laura Caseley For The Money Manual