Compound Interest

Situation

I have never been very good at math. If I set aside money and it earns interest or grows in the stock market, I know it should grow over time. How does that work?

Suggestion

That is a good question. The math associated with your finances can seem intimidating, but it doesn't have to be all that confusing. One key is to understand the concept of compound interest.

Compound interest is sometimes called one of the wonders of the financial world. Very simply, compound interest just means you earn interest on your interest. The terms "compounded daily", "compounded quarterly" or "compounded annually" simply refer to when the interest is added to the balance and begins earning more interest.

The Rule of 72 is an easy way to estimate relatively accurately the impact of different interest rates over different periods of time. The thing to remember is that money roughly doubles when the interest rate times the number of years equals 72.

• Money will double in 18 years if it earns 4%.
• Money will double in 12 years if it earns 6%.
• Money will double in 9 years if it earns 8%.
• Money will double in 8 years if it earns 9%.

While the Rule of 72 won't give you precise results, it is an easy way to get a general understanding.

That is pretty simple when you just consider setting aside one amount of money and letting it grow. For example, let's say you are 29 years old, thinking of retirement and currently have $25,000 to set aside for retirement at age 65. If you can earn 6% on the funds, it will grow to $50,000 in 12 years when you are 41. In another 12 years when you are 53, it will have doubled again to $100,000. In the last 12 years, it will double again to $200,000 when you are 65.

Where it can get confusing and where the power of compounding really comes into play is when you start with a single amount and then add to it over time. What would happen if you start with that $25,000 today, earn 6% annually but add $5,000 each year either from your savings or with contributions to a retirement plan like a 401(k) plan at work.

Here is a chart that demonstrates what happens when you add to your savings annually:

The numbers have been rounded a bit and there is an assumption that you earn 6% every year, but the results are impressive.

If you start with $25,000 and don't any more, it will have grown to about $180,000. However, if you save an additional $5,000 each year, you end up with over $800,000.

It is said that Albert Einstein referred to compound interest as the eighth wonder of the world. From looking at the chart, he may have been right.