Compound Interest: Your New Best Friend

Einstein understands the power of compound interestWhen I first started learning about personal finance 9 or 10 years ago, there was something I learned that blew my mind completely.

I had stumbled across the concept of compound interest.  While it’s beauty is acknowledged by experienced investors, it is something that the average person fails to grasp.

It didn’t even seem to make logical sense at first, but when it finally sank in I was amazed.  Honestly, this was one of those ‘holy shit’ moments where you realise things will never be the same again.

It’s one of the money lessons that changed my life.  Compound interest is basically where interest grows on interest, multiplying on itself over time.  Your initial investment will start to look ridiculous compared to how much it’s earning!

Here’s how it works.  Say you decide to invest a sum of $1000 and it earns a return of 7% per year – which is close to the long term return from shares.

After 1 year, your savings would have earned $70 and grown to $1070.  In year 2, you will now earn 7% on $1070. You will earn $74.90 in interest this time, giving you a balance of $1144.90.

Seems pretty slow going, right? But notice how the earnings are higher than the previous year.  Let’s take a look over a longer time frame. Check out this table to see it in action.

 

Starting from your initial $1000 investment…

Year Year Interest Balance
1 $70.00 $1,070.00
2 $74.90 $1,144.90
3 $80.14 $1,225.04
4 $85.75 $1,310.80
5 $91.76 $1,402.55
6 $98.18 $1,500.73
7 $105.05 $1,605.78
8 $112.40 $1,718.19
9 $120.27 $1,838.46
10 $128.69 $1,967.15
11 $137.70 $2,104.85
12 $147.34 $2,252.19
13 $157.65 $2,409.85
14 $168.69 $2,578.53
15 $180.50 $2,759.03
16 $193.13 $2,952.16
17 $206.65 $3,158.82
18 $221.12 $3,379.93
19 $236.60 $3,616.53
20 $253.16 $3,869.68
21 $270.88 $4,140.56
22 $289.84 $4,430.40
23 $310.13 $4,740.53
24 $331.84 $5,072.37
25 $355.07 $5,427.43
26 $379.92 $5,807.35
27 $406.51 $6,213.87
28 $434.97 $6,648.84
29 $465.42 $7,114.26
30 $498.00 $7,612.26
31 $532.86 $8,145.11
32 $570.16 $8,715.27
33 $610.07 $9,325.34
34 $652.77 $9,978.11
35 $698.47 $10,676.58
36 $747.36 $11,423.94
37 $799.68 $12,223.62
38 $855.65 $13,079.27
39 $915.55 $13,994.82
40 $979.64 $14,974.46
41 $1,048.21 $16,022.67

 

The points that stand out to me are:

After 41 years your investment balance is around 16 times what you started with.  Your investment is now earning more per year than your initial investment. 

Remember you invested $1000. Now it’s earning more than $1000 every single year! It is earning over 100% on your initial outlay.

See how the earnings column on the left, increases nicely every year because you’ve reinvested the earnings.  (here’s a post I wrote detailing exactly how we can do this – The Relentless Progress of a Dividend Investor.)

And it’s increasing at a faster pace too, thanks to the magic of compounding.  Remember, this is a measly $1000 investment that you just left alone.  Just imagine how it turns out when you are actually adding tens of thousands per year to the mix!

I do these equations in my sleep at night, being the finance nerd that I am, and it’s safe to say your balance will turn out well into the millions.

You get to decide when that million dollar mark rolls around for you. It’s up to you how much you spend, save and invest.  This blog will work on helping you improve all 3 of those to make the journey to financial independence as quick and easy as possible.

The more you’re saving and investing, the sooner you get your life back!  If compound interest is not working for you, you can be pretty sure it’s working against you.  Then there’s opportunity cost.

Seeing how the numbers multiply over time, it becomes clear that understanding this simple concept is exactly how and why the rich get richer.  It really is the Eighth Wonder of the World!

Don’t miss out on the magical, money multiplying power of compound interest. Get it working for you as soon as possible.

5 comments

    1. Great example Tim. Have read something similar before. It’s mind blowing. That should give us a good kick up the bum to get started and focus on the long term 😉

  1. Hello David,
    First of all thanks for the blog. It is both motivating and entertaining.
    I have been looking around in your posts, other F.I.R.E. bogs and multiple compound interest calculators but could not find a clear answer.
    I have been thinking of the best way of invest exactly $500/week making the compound interest work as soon as possible with the lower fee for investment possible. I use selwealth as well ($9.5 per transaction).
    I understand that keping the fee as lower as possible (Investments of at least $5000) would make our investment bigger. But If I have to wait 2 or 3 months to save that amount in order to keep fees low, I am missing out months of compounding for that money that is siting in a bank earning nothing.
    I am trying to find the sweet spot between low fees and compounding time, but every calculator I find on the internet is almost different. Some would say that one investment of $26,071 – $9.5 a year would make the most money at the end of 15 years. Other that $2,172 – $9.5 monthly would become ahead in the long run. And in other blogs I read that saving up to $5,000 and then invest it, would be better because of the low fees.
    I am quite new on the community and still making my plan for retirement. I am also aware that not every week is going to be the same. One after a big expense will decrease my regurar deposit while another one after the tax return will increase. I am just trying to find that middle point between low fees and compounding time for $500 a week. Once a month, Once I have $5000, Once every fortnight? I would really appreciate if you could guide me on this to start setting up my plan cause I could not find anything clear onthe internet.
    Best regards,
    Alvaro

    1. Thanks for the comment Alvaro. First off, great job for committing to a monthly savings plan. This point alone is a very good start and goes a long way to achieving your goals.

      There’s no perfect answer to your question, that’s why you can’t find an answer. There’s no need to invest more frequently than once per month. Even once per quarter is perfectly fine. The main thing is you’re investing regularly and doing it over time.

      With savings of $500 per week, I think monthly investing is a good idea. You’d have on average over $2000 each month which is enough to keep brokerage costs low and the monthly investing should keep you engaged and help you build momentum. If it’s a little more than this or a little less than this don’t worry about it. The main thing is that you’re still saving and investing regularly, so focus on being consistent. Hope this is helpful!

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