Updated on 02.13.12

Compound Interest, Compound Opportunity

One of the first topics covered in almost any personal finance book you read is the power of compound interest.

Compound Interest 101
You can skip this section if you’re already familiar with compound interest and how it works. I’m including it for people new to the idea.

Let’s say you have access to a savings account that pays 5% interest. You decide to put \$1,000 and let it sit for future emergencies. For easy math, we’ll say it compounds annually (meaning you only figure up the interest on it once a year).

At the end of the first year, that account has \$1,050 in it. You have your original \$1,000, plus you have 5% interest on it – \$50.

At the end of the second year, the account now has \$1,102.50 in it. You have the \$1,050 you had in it after the first year, but this year it earned more interest – \$52.50. Why? The interest earned during the first year is now itself earning interest. You didn’t just earn interest on the first \$1,000. You also earned it on the \$50 in interest from the first year – an extra \$2.50.

At the end of the third year, the account now has \$1,157.63 in it. You have the \$1,102.50 from the end of the second year, but this year it earned \$55.13 in interest.

Now, from the first year to the second year, your interest grew from \$50 to \$52.50 – an increase of \$2.50. From the second year to the third year, your interest actually grew even more – jumping from \$52.50 to \$55.13 is a \$2.63 increase in interest. Not only is the amount of interest growing from year to year, the amount that it grows each year is actually increasing.

At the five year mark, you’d have \$1,276.28 in the account.

At the ten year mark, you’d have \$1,628.90 in the account.

At the twenty year mark, you’d have \$2,653.30 in the account. Your money has more than doubled without you lifting a finger, and every single year, the money has grown more than it did the year before.

That’s the power of compound interest. It’s not impressive at first, but if you stick with it, it becomes a locomotive.

Compound Interest Is Great, But There’s a Catch
What’s the catch? In order to really enjoy the power of compound interest, you have to let your money sit for a long time.

In the example above, your money has doubled at around the fourteen year mark. Sure, it’s awesome that your money has doubled, but it took fourteen years for it to do so. That’s a long time. Think about where your life was fourteen years ago.

I was a college sophomore. I was dating the woman I would eventually marry. I had only met one of the large handful of people who would help me build my first career. My life was completely different.

The seeds of a success today were planted in that completely different life.

Compound Opportunity

The first thing you should do when you have some money to set aside for the future is to assess your goals. What do you want out of your life? What are your dreams? Your hopes for the future?

If things were to fall reasonably well, where would you really like your life to be next year? In five years? Ten years? Twenty years? When you’re 65? Those are the questions that should underline how you handle much of your money (outside of your basic bills).

Sure, we do spend some of our money for today, but spending all of your money for today means that you’re ensuring your tomorrow won’t be much better than today.

So, how do you most effectively turn that little bit of extra money today into the better life that you want tomorrow? There are lots of ways to do that – and they aren’t all found on the pages of a financial magazine.

Do you want a better – or at least different – career? The best way to get there is through education, and the best way to prepare for that is by putting your money into a 529 college savings plan for yourself for a few years, then making that leap.

What if you want something that doesn’t seem as directly related to finances, such as better physical fitness? That requires an investment of time and energy, not so much finances. Those are investments, too.

What if you want freedom from debt so that you don’t have the monthly bill stress and your boss doesn’t have as much power over you? That requires an investment, but it’s in the form of living lean and making extra debt payments.

In each case, the first little step you make doesn’t make a big difference. One day of exercise does not change your fitness level. One extra debt payment doesn’t rock your debt situation. A small amount in a 529 does not alone make for a new career.

Much like with compound interest, it’s the continuous steps that begin to build on themselves. Exercise several times a week and it becomes easier and more rewarding. Make an extra debt payment every month and the debt begins to melt faster and faster. Regular money in a 529 starts to build on itself, turning a dream of a new career into reality.

You can build the life you want. You just have to figure out what you want, then take steps every day to make that life happen, whether it’s a money step, an energy step, a time commitment step, or something else. The more steps you take, the easier they become and the more your efforts begin to reap rewards beyond what you expected.

Almost every success you have in life is an investment. Almost every success in life builds on the little steps you’ve put into it, growing beyond what you ever expected from them. A dollar in savings every day, a half hour practicing a skill every day, an energy-burning workout every day.

It all starts with the commitment to take those little steps and see a very small reward from those steps at first. Do it over and over again and those successes begin to compound. Stick with it and that investment begins to pay off in ways that change your life.

1. lurker carl says:

Why not use the actual rates banks currently pay? Easy math works the same with 1% as it does with 5%, the calculator doesn’t care what ‘large handful’ of numbers you punch in.

2. Jackowick says:

@Lurker Carl

Because 5% is closer to what you would get long term historically with CD rollovers or a money market if you’re able to look past the short term of the past 5 years or so and the next 5 years. I don’t base my stock market expectations for my 401k on the last year/5 years when it has 30 years to go.

But hey, it’s the internet, just focus on the now and feel good about it.

3. AnnJo says:

Something else compounds too – inflation. I’ve noticed Trent rarely if ever takes that into account in his posts.

During my lifetime, there have been few times when traditional interest-bearing investments (savings and money market accounts, CDs) outpaced inflation. In fact, about the only time I can recall that happening was during a housing bubble. Which stands to reason: if home loans are in high demand, then interest rates on the source of funds for such loans is going to rise to encourage depositors.

4. David says:

As usual… sigh … your money may have doubled, but because of inflation its value has been reduced. In the fourteen-year period from 1998-2011, the cumulative inflation rate in the USA was about 36%, so that \$2653.30 is “worth” about \$1690.68.

5. tentaculistic says:

I struggled through my finances courses (not so much a maths kinda gal), but thought that compound interest was SOoOo cool. Our professors almost always had us use the average rate of return of the stock market over time (10%) or average inflation (3%)… I was pretty disappointed to learn how unlikely 10% actually was nowadays (and I’m skeptical that our mature stock market is really going to get that kind of return again in the long run), and how much value 3% inflation strips out of your money. Inflation makes it so that investment is essentially the only long-term solution to keep your money’s value steady or growing.

There are some cool online calculators that allow you to teach kids (or adults like I was when I learned!) how compound interest works. TheMint .org has a kids’ compounding calculator (google it – if I put in the link this comment will end up in moderator’s purgatory).

Also really effective for learning/teaching is to look up an inflation calculator. The CPI Inflation Calculator, for instance, taught me that when a coworker said he bought a car in 1965 for only \$4,000 that is actually the same as \$28,500 in today’s dollars. Now if that same 1965 person had stuck \$4,000 under his mattress and pulled it out now, that \$4,000 would only buy a 1/8 (\$560) of what it would have bought in 1965. Whoa. That really hammers home the need to find something that gives you a return on your money.

6. Andrew says:

AnnJo, you are so right.

Bank interest rates are historically lower than the rate of inflation. Even in the 1970’s, when you could get 11% on your savings account, inflation was running at 15-18%.

Banks know this, and are not in the business of giving away money, even through the mechanism of compound interest. Trent’s example may look pretty, but it’s a hollow achievement.

7. AnnJo says:

Here’s a tip for a quick calculation on how long it takes for money to double (in a nominal sense ignoring inflation, not in a real sense).

Remember the number 72. Divide it by the interest rate, and you will know the doubling period. At 2% interest, your money will double in 36 years; at 12% interest, it will double in 6 years; and so forth. At current bank and CD rates, the doubling period stretches into the 56th century or thereabouts.

As an alternate investment for your consideration, I’ve earned 38% on the cases of tuna I bought on sale a year ago (or what’s left of them).

8. AnnJo says:

Andrew, “the banks” necessarily have to charge higher loan rates than they can afford to pay depositors. Otherwise they’d go out of business. And since most people still prefer fixed rate loans, the spread has to be fairly high so that banks don’t get slammed by inflation the way they were in the late 1970s.

Anyway, “the banks” generally don’t have the power to print money, which is the only way real inflation can take place – when new money outstrips new productivity. The federal government figured out a long time ago that if money supply growth could be detached from limitations such as the gold standard, it could secretly increase taxes without taking the political heat, and could do something the Constitution doesn’t expressly allow, namely, tax wealth instead of just income.

I put the term “the banks” in quotes, since I’m talking here about banks like Chase, Bank of America, etc. There is one bank, of course, that must collude with the federal government to implement the inflation tax, namely, the Federal Reserve Bank.

9. Tracy says:

I really don’t get this idea that you have to know exactly what you’re saving for in order to save (it’s something that pops up in Trent’s posts time and time again)

I mean, if you *have* a specific goal, than by all means, saving for it is fantastic.

But I think it’s just as important to save for the goals you don’t yet know about – the things that you might want to do in 10 years that you can’t even imagine you’d want to do now.

(Heck, even in this example, he talks about the seeds of his now-success were planted 14 years ago … but the Trent he describes from that time doesn’t share the same values or goals that he has now, it wasn’t until his ‘wake-up-call’ with his first child that he shifted)

Enjoy life now. Save so that you can continue to enjoy life in the future. Re-evaluate yourself and move forward.

10. Misha says:

Tracy, I see it too – over and over he pretends his life and finances have always been this way, which is actually pretty irritating if you’ve been here a while (or if you’ve read back in the archives to some of the earliest material) – it isn’t true, and Trent doesn’t seem to realize that his story is better if he leaves the truth of it in, instead of pretending he’s always had it all together.

11. valleycat1 says:

I can speak to the compounding benefit when paying down debt. It feels at first like that little bit extra isn’t getting you anywhere, and then you suddenly realize only a few more months & it’ll be paid off.

12. Katie says:

Actually, I think Trent’s finances were not actually that bad. He’s talked about moving money from retirement accounts to pay off a lot of his consumer debt (because he was ahead of where he needed to be for retirement at that point). So not to minimize his moment of clarity and turnaround, because clearly he did decide he was headed somewhere he didn’t want to be and make changes, I don’t think he was objectively at the point of disaster or destitute.

13. Kevin says:

@tentaculistic: Be careful – you’re making the classic mistake of conflating “interest” and “rate of return.”

“Interest” is what nothing more than the cost to borrow money. That’s savings accounts, money market funds, CD’s, bonds – any “loan” instrument. That’s it.

Capital gains made from owning stock, mutual funds, and other equity instruments produce a “rate of return.”

“Compound interest” has nothing to do with the stock market. That’s a compounded “rate of return,” and it’s not nearly as simple. You have to specifically re-invest dividends. Straight-up capital gains is not a “compounded rate of return,” it’s simple appreciation.

Confusing the terms like this is one of the reasons everybody is so surprised to learn that the “magic of compound interest” isn’t nearly as magical as was advertised, particularly over the past decade or so.

14. Squirrelers says:

The power of compounding is substantial, and the concept should be taught to people early on – as in, high school. Not just in math sense, but the basic math applied to financial goals and savings. If many people truly had this concept ingrained in their minds, they might be more likely to save and invest when young – thus, alleviating problems later in life.

15. Johanna says:

This is an example of what I mean about articles that start in interesting places but all end up in the same place. The connection between setting long-term financial goals and long-term nonfinancial goals is (potentially) an interesting idea, but it doesn’t really hang together, so the article ends up just saying “You should set financial goals, and also, you should set nonfinancial goals,” both of which are ideas that Trent has expressed about a hundred and thirty-seven times before.

16. Kevin says:

@10 Misha – I think it might be the reverse. Trent would have us believe he used to light cigars with \$100 bills, but one night rocking his son he had a complete turn around. This all seems a bit too perfect for me. My guess it that he was never really that bad – maybe he just fine-tuned things a bit. The idea of completely changing your life in a moment of clarity doesn’t strike me as realistic. Whenever I’ve mad changes it’s always been a much longer process.

17. lurker carl says:

@ Jackowick – Compounding interest is a math exercise but it does not perform like that in real life. Trent’s saving account, which attempts to teach an algebraic formula via priciple instead of math, doesn’t reflect actual rates of return or taxes or inflation or bank fees or anything else.

Nothing can expand exponentially forever, not at 5% or even at 1% growth each year. That is mathematically impossible. Everyone would be millionaires without a lick of work, that is impossible as well. Money can not be created out of nothing without making the existing cash worth less.

The past 60 years do not reflect reality, it has been a giant bubble and the American economic engine is sputtering into a slow and painful deflation. Zero interest is the new normal and the Fed will not raise interest rates for a very long time. One lost decade becomes two lost decades becomes a lifetime.

18. Arvin says:

Why not use current savings account rates, since part of good personal finance is to not assume that things will get significantly better in the future? Specifically that interest rates for savings accounts now, at 1 percent or less, would quintuple again in the near future and stay there.

At 20 years of 1 percent interest your 1000 dollars will have grown to 1220, no 2653. The only thing more sobering than that fact is not keeping your cash in ANY interest bearing account.

19. tentaculistic says:

#13 Kevin – you’re right, I was substituting bank interest with stock market return. Does it make a difference? (honestly asking – as I said I struggled through finances courses) I am thinking the main difference is that until you actually cash out your stock, it’s all imaginary value, whereas in a bank account it is real money?

20. jen says:

CD’s at my CU can get 1.55% at their highest. Not too inspiring but I’ll put my emergency fund there anyway.

21. Arvin says:

#19 – With your stock, you’re assuming that the stock price will continuously go up, there’s no compounding of interest, and the price can certainly go down. You’re just buying property that is worth nothing until you sell it, and the price you sell it is dictated by what the market is willing to buy. With a savings account, it’s money you can withdraw at face value at any time, most likely insured by the FDIC, and DOES accumulate interest withdrawable value.

22. tentaculistic says:

#21 – ok, so it’s basically risky stocks (with the possibility of higher return, or of much lower return) vs guaranteed interest (but lower than potential stock returns)?

23. AnnJo says:

#22 tentaculistic, putting money in savings accounts or CDs practically guarantees you will lose money in terms of purchasing power. There are reasons, related to liquidity and to hedge the risk of deflation, for keeping money in cash, but diversification of investments is critical.

Within the universe of stocks, there are quite a few that offer relatively high and relatively reliable dividends that make up for quite a bit of the risk, given today’s interest rates.

If you invest in a stock that pays a reliable and attractive dividend yield at its current price, as long as the dividend amount is kept stable over the long term (or rises), you can afford to lose a lot in the stock price as long as you don’t need to sell and you’re investing for income.

For example, if I am investing in order to generate \$500 a year in income over the long term, investing \$10,000 in a stock that costs \$100 a share and pays \$5 a year in dividends is equivalent to investing \$50,000 in a 1% CD. They both generate \$500 a year. And as long as the stock continues to pay a dividend of \$5 a year per share, it is pretty trivial if the stock price drops to \$80 – as long as you don’t need to sell.

24. AnnJo says:

In the comment above, I should have said, “pays \$5 a year PER SHARE in dividends.”

25. Annie says: