Compound interest is defined as interest which is calculated not only on the initial principal but also the accumulated interest of prior periods.
Before I show you how compound interest works, I want to discuss something called the “Rule of 72.” This rule is a quick way to see how long it will take the money you invest to double. The way to determine this is to take 72 and divide it by the percentage of interest you are earning on your money. For example, if you average a 5% return on your savings, you will double your money in 14.4 years (72 divided by 5 equals 14.4). If you average 8% return on your money, you will double the amount you invest in 9 years (72 divided by 8 equals 9).
Try it yourself. Let’s say you average a 10% return on your retirement account. How long will it take for this money to double? If you came up with 7.2 years you got it since 72 divided by 10 equals 7.2. Let’s take a closer look and see exactly how compound interest works.
To make this easy, we are going to pretend that you invest $100 and this $100 investment averages 9% growth each year. Using the Rule of 72, this $100 will be $200 in 8 years (72 divided by 9 equals 8). The following chart shows you exactly how this works:
Year Interest Earned Total Amount of Money
0 $0.00 $100.00
1 $9.00 (9% of $100.00) $109.00
2 $9.81 (9% of $109.00) $118.81
3 $10.69 (9% of $118.81) $129.50
4 $11.66 (9% of $129.50) $141.16
5 $12.70 (9% of $141.16) $153.86
6 $13.85 (9% of $153.86) $167.71
7 $15.09 (9% of $167.71) $182.80
8 $16.45 (9% of $182.80) $199.26
What an amazing concept! Now you can see how investing a set amount each month (dollar cost averaging) can lead to great financial success. Here is another example of the magic of compound interest.
John and Jeremy were friends since they were little. As they got older, they both knew they should start thinking about their futures. When John turned 19, he decided to invest $2,000 every year (under $167 a month) for eight years. He picked mutual funds that averaged a 12% interest rate. Once he hit 26, John stopped investing. So he put a total of $16,000 into his investment funds. Jeremy waited until he had a better-paying job at age 27 before saving for retirement. Just like John, he put $2,000 into his investment funds every year until he turned 65. He earned the same 12% interest rate as John but invested 31 more years than John did. He ended up investing a total of $78,000 over 39 years. Fast forward to when they both turned 65. Who do you think had more? John, with his total of $16,000 invested over eight years, or Jeremy, who invested $78,000 over 39 years? It turns out John came out way ahead! Jeremy had a total of $1,532,166, while John had a total of $2,288,996. How is this possible? Well, John had the power of compound interest on his side longer than Jeremy and, thus, came out over $700,000 ahead of Jeremy even though he invested a lot less.
Even Albert Einstein had an opinion about compound interest. It is rumored that he once said that compound interest is the greatest mathematical discovery of all time. Coming from the mouth of the man that discovered the Theory of Relativity shows that compound interest must be some pretty powerful stuff.
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