In a previous article, I talked about interest and its relationship with loans, credit, and borrowing. In that context, interest is perceived negatively because it's money you have to pay on top of the amount you borrowed. Today, I’ll be talking about a concept called compound interest, and how it's extremely beneficial when it comes to saving and investing your money.
First, let's talk about interest in the context of saving and investing. Interest in this sense is a percentage you receive when you deposit or invest your money. Just as banks charge interest because you are borrowing their money, in this case, you receive interest because you are, in a nutshell, lending other people your money.
You might be asking, “I’m not lending my money to anyone, I’m putting it in a savings account”. Well, when you deposit your money into a savings account, the bank will take some of your money and loan it out to someone else. They’ll loan it out in the form of credit, a mortgage, or an auto loan, to name a few examples. Even though this may seem risky, short of an economic collapse, banks and other institutions will always have enough cash on hand to give you your money back in case you decide to make a withdrawal.
To reward you for letting them loan out your money, banks will offer you some of their profits from whatever they lent out. This is in the form of interest. Interest is a set percentage of the amount you have in the account, and it’s paid out periodically by the bank. However, most savings accounts usually have extremely low-interest rates, many being under 1% per year.
For example, if you have $100 in a savings account with a bank that offers 1% interest, the first year your account is open, the bank will pay you $1 (1% of $100).
When it comes to investing your money, interest isn’t paid like it is with savings accounts. There is no guarantee that you will receive money every year, and the percentage will always vary. The amount you receive depends on how well the assets (stocks, bonds, index funds, etc) you invested in did. If your asset goes down in price, you will lose money. On the other hand, if your assets go up in price, the profit you make can be thought of as “interest”.
You may have seen some people acting like investing in the stock market gives you interest and guaranteed profit. While this isn’t entirely true, it does have some basis. The S&P 500, a US stock index representing 500 of the biggest companies, has provided somewhat consistent returns throughout history, averaging anywhere from 7-10% per year for the last 90+ years. This consistency is why investing in index funds and the overall stock market can be considered to provide interest.
Although there are some years in which the stock market does poorly, the majority of the time, the overall markets have done well, providing steady returns. This means the yearly profit/loss averages out over a long period of time, despite some years being better than others. This is also why investments like index funds are considered to be relatively low-risk.
Now that we’ve established how interest can be beneficial to you, let's talk about compound interest specifically. This will involve some basic math, so buckle up!
Compound interest is the process of earning interest on interest. So, as you save/invest money, and receive a regular percentage return through either profit or interest, that additional percentage, however small, is added to your total sum. This means that your initial deposit/investment will grow over time. Even though the percentage stays the same over the years, the dollar amount increases.
This might be a bit difficult to visualize, so let's look at an example.
Say you deposit $100 in a savings account that gives 10% a year (a delusional percentage, I admit, most banks won’t give over 1%).
In the first year, you’ll earn $10, which is 10% of $100 ($100*0.1). You now have $100, your starting amount, plus the $10 from interest, for a total of $110 ($100+$10 interest = $110).
In the second year, you’ll earn 10% of $110, which is $11. Notice how the amount of interest you earned increased from $10 to $11, even though the percentage didn’t change? This is just a small hint at what compound interest can do. At the end of the second year, you’re left with$121 ($110 starting amount + $11 interest).
In the third year, you’ll receive $12.1 in interest (10% of $121). Now, you have $133.1 (starting amount of $121 + $12.1 interest). Again, your interest rate stayed the same, but your dollar amount earned went up.
In the fourth year, the same phenomenon occurs again. You start the year with $133.1, earn 10% interest, which equals $13.31*, and end the year with $146.41.
Notice how the amount changes every year, yet the percentage stays the same.
*An easy way to calculate 10% of any number is to simply move the decimal point over one spot to the left, so 133.1 turns into 13.31.
This pattern will continue forever, as long as you receive a standard interest rate every year. In 10 years, you’ll have $259.37, your starting amount. In 20 years, you'll have $672.75. And in 40 years, you’ll have $4,525.93. All this from an initial investment of just $100. Here’s a visual representation of that growth.
From the graph, you can see that time is extremely valuable. The more time you have, the more your money will grow. That's why it's so important to start saving, and even investing, at a young age. You have the power of time on your side. Don’t think that just because you can’t save or invest a huge amount, that you shouldn't start. Even small amounts of money can grow into small fortunes through the power of compounding, as you saw with the $100 turning into over $4,500.
investor.gov/financial-tools-calculators/calculators/compound-interest-calculator is a great resource if you want to see how money will grow at different interest rates.
From the graph, you can see that time is extremely valuable. The more time you have, the more your money will grow. That's why it's so important to start saving, and even investing, at a young age. You have the power of time on your side. Don’t think that just because you can’t save or invest a huge amount, that you shouldn't start. Even small amounts of money can grow into small fortunes through the power of compounding, as you saw with the $100 turning into over $4,500.
Compound interest plays a key role in the time value of money, a concept I’ll discuss in the coming weeks. It’s also important to note that compound interest can be a part of loans too. I’ll talk about compound interest and its relationship with loans/credit in the third part of the Interest miniseries.
In short, compound interest is a valuable part of personal finance. Learning about it and starting to save at an early age is extremely beneficial. Through compounding, a small starting investment can turn into a massive amount over the years. You harness the power of time, and earn interest on interest, increasing the amount of money you earn each year, despite receiving the same percentage.