You’ve probably heard the term “the magic of compound interest.” If you don’t understand compound interest, it probably does seem like magic. But it’s actually a pretty simple concept once it’s explained properly.
Interest is money given to you when other people or businesses hold a sum of cash for you. In general, interest is figured annually, but keep your eyes open; credit card companies often state that they charge something like 1.7% every billing period, which may be monthly or more frequent. The two most common types of interest are simple and compound.
Simple interest is interest paid on the principal, or a sum of money you owe or have invested. If you receive 5% simple interest on this money every year, then you will have your original principal plus 5% of its value at the end of each year. For a practical example, if you have $1000 in a savings account and you neither add to nor take away from it, by the end of the year you will have an extra $50, for a total of $1050. You may receive interest parceled out over the year, too; if you receive 5% annual interest figured into your account every month, then you’ll get about $4.50 a month. When your interest is paid to you, you can decide whether to add it to your capital or not.
Compound interest is added to the principal automatically when paid, and interest after this is figured on the whole sum — principal plus interest. This is where the magic comes in. On that $1000 capital above, if you get interest that is compounded annually, at the end of the first year you’ll have $1050, but at the end of the second year you’ll have $1152.50.
If your interest is compounded monthly, at the end of the first year you’ll have $1052 — slightly more than with simple interest. The difference is, starting with the first interest payment, you receive interest paid on interest. For example, if the Manhattan Indian tribe had invested the $24 they received for their island in a bank that paid 6.5% interest compounded annually, today they would have over $820 BILLION in the bank, more than the value of the island they sold.
The most telling difference between simple interest and compound interest is how long it takes to double your money. With simple interest, it takes 20 years. With compound interest, however, it takes only 13 years. And that’s assuming you don’t add any cash to the account, and that you only have a 5% return.
How You Can Benefit
You may not be able to save for 400 years and reach the fictitious heights of the Manhattan Indians, but you can make compound interest work for you. Start by saving a certain amount of cash every month. Put it into a bank account that gives you a fair interest rate, at least 5%, and don’t take it out except to invest in even better interest-bearing accounts (CDs and mutual funds, for instance). The first five or six years will probably not seem to grow. But if you continue adding about 10% of your salary, you’ll have more than enough to retire on in 30 years.
For example: assume that you make $25,000 per year. 10% of this ($2500) added into a 5% interest-bearing account that compounds interest every year will be $82,000 in 20 years, and $166,000 in 30 years
If you find a 6% account, these numbers go up to $91,000 and $197,000.
And if you continue refiguring your 10% as your salary increases, you’ll see even higher rates of return.