There is one thing that can truly alter the way you look at saving and investing and that is compound interest. We’re not sure if it’s an actual quote by Albert Einstein, but in any case, the idea is correct; that compound interest can accumulate to great amounts over time with consistent investments, and the only thing you have to do is let your money work for you.

Let’s first understand what compound interest is, how it works and why investing early even at low amounts can have a greater impact than most would think.

Compound Interest: What is it?

Compound interest is any interest that is calculated on the principal (the amount of money) AND on the interest that the money has already earned. That is, your money receives interest, and the interest receives interest as well.

It is unlike simple interest, which gives interest on your principal only regardless of the period during which the money remains invested.

If you invested $1,000 in an account that has an annual simple interest rate of 5%, you would receive $50 each year forever, $1,000 x 5%. However, if compound interest were added to the interest each year, after the first year you would have $1,050, and after the 2nd year you would earn 5% interest on the new amount of $1,050, not the original amount of $1,000. It may be a couple of extra dollars in year 2, but over years this snowball effect can be quite a lot.

The Compound Interest Formula

If you’re interested, the basic compound interest formula is:

A = P (1 + r/n)^(nt)

Where:

P = principal (initial amount)I = interest earned
P = Principal (starting amount)
r = Interest rate per year (as a decimal)
n = number of times the interest period is split into to get the compound interest.
t = number of years

There is no need to memorize this to make use of compound interest, however it is beneficial to know that there are two factors that are often very significant: time (the “t” in the formula) and how often the interest is compounded (the “n”).

Why Time Matters More Than Almost Anything Else

Now comes the real power of compound interest: the sooner you begin saving the less you need to contribute towards your ultimate end goal—because time does a whole lot of the work for you.

Suppose two individuals have the goal of saving money by the time they reach 65, with both having an annual return of 7%:

At age 25, person A begins investing $200 a month and ceases all contributions at age 35 (after 10 years, or $24,000 total contributions). Until the age of 65, they don’t touch that money.

Three times that amount is invested by person B starting at age 35 and increasing by $200/month until age 65 (30 years of investments, totaling $72,000).

Although Person A gives in a total of £3 times less than Person B, the person who started to invest earlier and allowed the compound interest to grow for a longer period of time, often ends up with a similar or larger final amount than Person B. This is the primary reason why financial professionals always recommend getting a head start, no matter how small the amount!

How Compounding Frequency Affects Growth

The other “n” in the formula is also important – the number of times per year that interest is compounded. Some of the more common compounding frequencies are:

Annual – it is calculated once a year Monthly – it is calculated 12 times a year Daily – it is calculated 365 times a year

The more often a compound is compounded, the sooner the interest starts earning interest, which means the growth rate is slightly higher. For a savings account, the savings amount on an annual basis and the savings amount on a monthly basis are usually quite close to each other in dollars and cents, but when considering savings accounts or investment products, it is best to use the advertised annual percentage yield (APY), which is typically calculated with annual compounding.

Compound Interest Works Both Ways

One thing to mention here is that compound interest does not necessarily favour you, it can bite you as well. For instance, credit card debt may add up by the day or the month. If you have a balance, then the interest you owe is added to your balance and then you will have to pay interest on that bigger balance. That’s one reason why credit card debt can accumulate quickly when you don’t pay the bill, and you can do the same in a savings account, but in reverse.

Practical ways to make compound interest work in favour of you

Begin as early as possible and as small an amount as possible. As illustrated, it is often more valuable to make a contribution over a longer timeframe rather than a large contribution all at once. As little as $25 or $50 a month, in your 20s, can add up significantly by retirement.

Reinvest your returns. When you invest in dividend stocks or interest bearing accounts, you should consider reinvesting the dividends or interest in an account so that the compounding effect can grow on a larger base with each dividend or interest payment.

Be consistent. Small, regular deposits are more effective over time, in part because they are compounded, but they also help to create a habit to deposit that is easier to sustain.

Don’t carry a high interest debt. With debt much like with savings, compound interest can work for you or against you, which is why it is best to pay off balances on high-interest debt, such as credit cards, to save money that would be accrued when it works against you.

A Quick Mental Model: The Rule of 72

The Rule of 72 is a quick guide to estimate the time it takes for an investment to grow by double, without having to use the formula. Simply divide 72 by your annual interest rate (as a whole number, not a decimal).

Using the example above, if a bank offers 6% annual return, then it will take about 12 years to double your money (72 / 6 = 12). With an 8% interest rate, it would take about 9 years. Again, this is not exact but a handy guideline when it comes to an educated guess when it comes to growth periods.

Final Thoughts

Compound interest rewards patience and consistency more than almost any other factor in personal finance. You don’t need to predict the market, time your contributions perfectly, or have a large sum to start with, you simply need to start, stay consistent, and give your money time to do what it does best: grow on itself.

Whether you’re saving for retirement, a home, or just building a financial cushion, understanding compound interest is one of the simplest ways to make your future self considerably better off.

Disclaimer:

This article is for general informational purposes only and does not constitute financial advice. Investment returns are not guaranteed, and past performance does not predict future results. For guidance specific to your situation, consult a licensed financial adviser.