When it comes to investing, time is your most valuable asset and compound interest is your best friend. If you’ve just landed your first job or are getting started on a side hustle but aren’t exactly sure what that “compound interest” phrase in the last sentence means, you’ve come to the right place.
As a young person, you’re in a great position to make your money start working for you. Why? Growth accelerates over time, and you have a lot of time ahead of you--meaning saving early pays off big time in the future. Here’s everything you need to know about compound interest and how you can take advantage of it.
What is compound interest?
To understand compound interest, you first have to know about simple interest. Simple interest is the interest earned on your savings only. Let’s say you have $100 you want to invest. This is called your principal balance. You go to the bank and deposit it into a savings account at a 1% interest rate. This means after your principal balance of $100 has been in savings for one period (typically defined as a year), you will accrue 1% on your investment, or $1. This keeps repeating annually, which means the next year, you get another 1%, or $1, and so on. That is simple interest.
Compound interest, however, is the interest you earn on both your principal balance AND the interest you earn over time, causing your wealth to grow faster over the course of your life. Remember learning about exponents in school? Compound interest is a similar concept.
Let’s go back to that initial $100. Suppose you deposited this same amount into the bank at a 1% compound interest rate annually. How does that grow differently than a simple interest rate does? Well, after the first year, it doesn’t. Your principal balance will have still made you the same amount of money: $1. But the next year, you will be accruing 1% interest on your new account balance of $101, instead of your original deposit, that principal balance of $100. Instead of making $1 on the sum, you make $1.01, bringing your new account balance to $102.01. The next year, that $102.01 accrues 1% interest, becoming $103.03. This continues to compound, or multiply upon itself, increasing how much you earn the next year, the year after that, and so on.
How does compound interest work?
Because compound interest includes all interest previously accumulated, it grows at an ever-accelerating rate. That’s why the number of compounding periods, or years you have been saving, makes a significant difference–and why you want to start investing as early as possible.
When you put money in a compound interest-earning account and leave it alone, your money will grow. In the previous example, you put away just $100 one time and let the compound interest do the work. However, if you were to add more money to your principal account balance on an ongoing basis–say, quarterly, monthly, or even every paycheck–your money can really start working for you.
Of course, it’s hard to imagine putting away money consistently when you’re young and starting from scratch with your finances. The benefit of doing so, though, is very real. Investing a little every month, even just $100, from a young age has the potential to eventually grow into a substantial sum of money for you to rely on when the time comes to retire.
What does compound interest look like in practice?
Compound interest in real life looks different depending on where you’re investing your money, how much you’re putting away, and your rate of return.
Consider the following scenario.
Investor One, Charlie, started saving at 25. He put away $1,000 per month for 10 years until he turned 35. Then he stopped saving but left his money in his investment account where it continued to accrue at a 1.5% rate until he retired at age 65.
Investor Two, Molly, started saving at 35. She also put away $1,000 per month for 10 years until she turned 45. Like Charlie, she left the balance in her investment account, where it continued to accrue at a rate of 1.5% until age 65.
Investor Three, Max, didn’t start investing until age 45. He too invested $1,000 per month for 10 years, halting his savings at age 55, then left his money to accrue at a 1.5% rate until his 65th birthday.
All three investors contributed the same amount, $120,000, to their savings over a span of 10 years. Yet because of when they began saving, their end results at retirement where drastically different. Charlie ended up with a balance of $203,105 in savings, while Molly had $174,831 and Max only had $150,492.