Compound Interest

Compound interest has been called 8th Wonder of the World. It can be a double-edged sword, benefiting those who use it to build wealth, and burdening those who accrue interest on loans and dig themselves into deep financial holes. This alert discusses the basics of compound interest and the effect it has on your financial future.

What is compound interest and how does it work?

Compound interest is interest calculated on an amount of principal (e.g., a deposit or loan) including all accumulated interest from prior compounding periods. Put more simply, it is interest on top of the interest previously added to the principal. Compound interest causes principal to grow exponentially over time. In the case of invested assets, it is a powerful tool to build wealth. However, for those who pay compound interest on loans, it can dig a deep hole that may be difficult to escape.  

Example of how compound interest can help build wealth:

Warren recognized early in life that if he routinely saved and invested, he could accumulate wealth and live a better life. He started investing at 22, adding $500 per month to an account which held an index fund tied to the stock market. The index fund returned 7% per year for the next 40 years, when Warren retired at the age of 62. The initial $500, and the monthly contributions thereafter, grew to almost $1.2 million thanks to time, compound interest, and Warren’s investing strategy.   

Warren’s friend Charlie wasn’t able to put away as much as Warren during his career, but he invested a $10,000 inheritance at 22 in the same index fund. Charlie’s investment, despite him not adding any more money to it, was worth almost $150,000 when he turned 62.  How? Time and compound investment returns caused Charlie’s inheritance to grow without him adding a penny.

Example of how compound interest can dig financial holes:

Brandon took out student loans to fund his education, finishing school with $50,000 in student loans at a 7% annual interest rate. Brandon was not able to find a job in his field with a competitive salary, so he entered an income-based repayment program to make ends meet, paying $200 per month. While the repayment program freed up money to help him pay his monthly bills, the payments were not enough to cover the interest on his student loans, much less the principal. After ten years, Brandon’s loan balance grew from $50,000 to $65,866, despite making payments every month. Time and compound interest caused his loan balance to grow.

Brandon’s sister Amanda wanted to go on vacation, but had not saved enough money. Instead of scaling back her plans, she booked a trip to Tahiti on her credit card. Unfortunately, Amanda was unable to pay off her credit card balance, and the interest charges began to compound. Amanda went from owing $10,000 to owing more than $10,786 one year later, even though she paid $150 per month. The credit card’s high 25% interest rate meant that Amanda’s $150 payments didn’t even cover the interest on her debt each month.  

How can I make compound interest work for me?

• Don’t just save — invest! To take advantage of compound interest, your savings must be in an account that pays some kind of return on investment. That rate will depend upon the amount of risk taken. Higher rates of return are associated with higher risk of loss, and lower rates of return are associated with lower risk of loss.   

• Start as early as possible: Time is one of the most important elements of compound interest. The longer your money is invested, the more opportunities it will have to grow. A 25-year-old who puts away $500 a month until age 65 with a 7% rate of return would have nearly $1.2 million, while a 35-year-old doing the same thing would have only $567,000 at age 65.  The earliest years of investing are the most important when it comes to compounding.

• Be consistent and patient: Consistent contributions to an investment account over time gives compounding more principal to compound on and can enhance returns. As Warren and Charlie discovered, even modest contributions, paired with investment returns over long periods of time, can help you reach your financial goals.  

• Check it out for yourself: The U.S. Securities and Exchange Commission has a compound interest calculator available on its website. Look at what your savings could look like based on different timeframes and rates of return. 

What can I do to avoid the pitfalls of compound interest?

• Be discerning about debt. Don’t take on unnecessary debt like Amanda did. Make sure you only take on debt that you can afford to pay back, at an interest rate that won’t hinder your ability to save for your future.  

• Pay down high-interest debts. If you already have high-interest debt, refinancing to a lower rate could be a solution for you, but might not make sense for everyone. Do your best to pay off high-interest debts before the compound interest takes its toll on your finances.  

The Bottom Line

Use compound interest to your advantage, and invest for your future.  Be cautious in taking on debt and understand how compound interest can derail your finances.