The Unrelenting Power of Compound Interest

The following is an excerpt from the book The Sound Mind Investing Handbook - A Step-By-Step Guide To Managing Your Money From A Biblical Perspective 5th Ed. FYI, the levels referred to below are the various levels within the Sound Mind Investing strategy. Level 1 is getting debt free, Level 2 is saving for future needs, Level 3 is investing your surplus, and Level 4 is diversifying for safety.

Sometimes, Level Two folks feel they can’t do anything very exciting from an investing point of view.

The folks at Levels Three and Four seem to have all the fun. Meanwhile, you’re still trying to save $10,000 for those “contingencies.” It can seem like an impossible task. If you feel that way, you’re short-changing the impact you can make. The power of compounding works to help you as you save.

For example, let’s assume you’re starting today with nothing in the bank. If you can save $10 each week and put it in a savings account, it will grow to $10,000 in 14 years. Admittedly, that seems pretty far away. How about working harder on your budget and increasing your savings from $10 a week up to $30? That gets you to your $10,000 goal in just 5.7 years. That’s much better. And if you start out with $4,000 in the bank rather than from scratch, the time required drops to only 3.2 years.

You can alter the variables to fit your particular situation (see table at left). Just keep in mind that every dollar in additional savings and interest earned contributes to the compounding process and gets you to your destination that much faster. You can achieve your Level Two goal sooner than you think through commitment and careful planning.

Many years ago, I came across a book with a rather unforgettable title: Money Makes Money, and the Money Money Makes Makes More Money.

As you might expect, it was about the power of compound interest. The word “compound” refers to something composed of two or more parts. Familiar examples include a chemical compound (a substance composed of two or more elements) and a hospital/medical compound (a building where two or more functions, like surgery, doctors’ offices, nursing care and laboratory, are combined into one large facility).

In financial terminology, “simple” interest refers to interest being paid on the principal only. Assume you deposited $1,000 in a one-year bank CD that paid simple 7% per year interest. After the first month, you would have “earned” a small amount of interest, around $5.83. But the bank isn’t going to pay it to you until the year is up; it is going to hold onto it. And even though it’s yours, it is not going to pay you any interest for having it around to use over the coming year. The bank is obligated to pay you interest only on one part of your account—your principal. After the year, you’d have earned $70.00 in simple interest.

Now, let’s change the terms of the CD to one of “compound” interest, where interest will be paid on both the principal and the monthly interest earned as the year goes along. The first month, the bank pays you only on your principal, just as before, because you haven’t earned any interest yet. But after the first month, it credits your account with that $5.83. Now, for the coming month, you’re going to earn interest on $1,005.83 instead of your original $1,000.00 of principal.

The second month you earn $5.87 in interest, only 4¢ more. By the end of the year, you’ve earned total interest of $72.29. That’s $2.29 more than simple interest would have paid, and it came your way just by changing one word in the CD agreement and without increasing your risk. Suppose we change the CD to pay weekly compounding. Instead of giving you credit for your earned interest just once a month, the bank will do it once a week. It turns out that at year’s end you’ve earned $72.46 in interest.

Daily (or “continuous”) compounding has become the most common offer. If we used daily compounding in our CD example, the total interest earned would have been $72.50. That’s the same as a simple interest rate of 7.25%. So, by changing from simple interest to daily compounding, you would have effectively improved your return by ¼% per year.

Does it seem too small an amount to really matter? For just $1,000 and for only one year, perhaps so. But when you consider how much you will have on deposit in a savings account over your lifetime, the difference of ¼% per year in return can amount to tens of thousands of dollars.

The unrelenting power of compound interest is one of your greatest investing weapons.

Consider this updated version of the saga of Jack and Jill. Jack started a paper route when he was eight years old and managed to save $600 per year. He deposited it in an IRA investment account that earned 10% interest. Jack continued this pattern through high school and “retired” from the paper-
delivery business at the ripe old age of 18. All told, he saved $6,600 during that time. He left his savings to compound until he reached 65 and never added another dollar during the entire intervening 47 years.

Jill didn’t have a paper route, but waited until her post-college days to start her savings. At age 26, she was sufficiently settled to put $2,000 into her IRA retirement fund. This she continued to do each year for 40 years. She also earned a 10% compounded return on her savings. Now, the question is which fund was larger at age 65—Jack’s IRA into which he put $6,600 or Jill’s into which she put $80,000?

Surprisingly, Jack is the winner. His IRA has grown to more than $1,078,700, an amount equal to more than 162 times what he put in as a child. Jill also did quite well with hers, which grew to $973,700. But Jack’s earlier start, even with smaller amounts and deposits for far fewer years, was too much to overcome thanks to the tremendous power of compounding. That’s because when Jack was 26, the age at which Jill began her IRA savings, the interest earned in his account was more than the $2,000 Jill was putting in. The moral is: invest early and often—even small amounts can make a big difference!

Comments

[ThinkingFinance]

I remember when I was in middle school we wrote a computer program that showed us the power of compound interest. THIS IS THE POWER OF INVESTING. Its how the rich in this country get richer. Imagine being able to post 10% returns each year by investing in stocks, currencies or commodities. You'd double your money in 7 years time.

At ThinkingFinance.net we teach people how to harness the power of compound interest through investing.

[Baker @ ManVsDebt]

My wife and I are young and are extremely interested in harnessing the power of compound interest as soon as possible. Right now we are in the middle of a War on Debt, but as soon as we succeed we are going to start using the theories of compound interest like no other!

[SJ]

Actually the cool part of this is that it doesn't go to infinity.

[rw]

This article made some crazy assumptions.

"Assume you deposited $1,000 in a one-year bank CD that paid simple 7% per year interest."

I never in my life came across a CD that pays 7%. If you know one, please enlight me.

Stop mis-guiding your readers with that magical & rosey 10% yearly return on investments. How about telling your reader the potential lost of 50% in just 5 months. This article just doesn't present all the facts.

This article has no moral in itself.

[FMF]

rw --

Maybe you should do some research. Found this after 10 seconds on Google:

http://www.jumbocdinvestments.com/historicalcdrates.htm

CD rates were over 7% in 2000.

I assume, based on your comment, that you're less than nine years old.

[Richie]

I agree with rw. 10% yearly returns, every year for abt 47 years are very rare.

[james]

rw is right. The assumptions in this article are ridiculous in light of the carnage we've seen.

10% return on investments? A simple 7% cd? Lets be honest, the only funds who delivered these kinds of returns in the past DECADE were run by guys named Madoff and Stanford.

But in spite of that, in spite of where we've been, I think that going forward it might not be unreasonable to expect 10% returns on equity investments over a 10-20 year time-frame. The time to be bearish on the markets was at S&P 1500. At 800, I'm more agnostic. At 600 and lower, I'm a raging bull.

Think of it like this. At 600, a 10% rally in the S&P over the next ten years only takes us back to the old highs.

CD's? At one time, 20% yields (late 70's) were the norm. But since then, interest rates have been heading lower, to the point that in months we should be able to lock down a 30 year mortgage at 4% (where I think the Fed wants rates to go). That's insanely low if you think about it.

The point being, rates are -- in my estimation -- as low as we'll ever see them, and that the path of least resistance likely points to higher rates over the next decade, and thus (much) higher CD yields.

So while the assumptions in the article may seem silly and dated based on where we've come from, they appear more realistic (i.e., attainable) based on the current field position of the markets, and what I perceive to be generational lows on the interest rate front.

[LotharBot]

Of course, 10% interest consistently every year for 50-ish years is pretty unlikely. It's more likely to see several years of 10%, a few years flat, a few years negative, then some years back at 5%, and so on.

The general idea that starting early gives you an advantage is true. Even with some down years and some average years, over time your money does build up, and if you get started a couple decades early, in good years you'll be earning more in interest than you initially put in in principal.

But of course the right strategy is to do both what Jack did and what Jill did -- get started early, and then keep investing. Watch your expenses, watch your asset balance, and keep building your asset portfolio.

[Justin Philips]

Compound interest truly works. However, later on you got to pay Uncle Sam from the capital gains.

[rabbit]

The Unrelenting Power of Compound Interest article is to show a point not to tell you that there are CD's out there that will pay you 7%. Since the Great Market Crash of 1929 the stock market has AVERAGED a 10% return per year. It didn't say that you were guaranteed of getting that return every year. You may get 20% 1 year and 5% the next but it averages 10% a year. Why do some of these people start acting like what is said is what is guaranteed? It is just trying to show you how compound interest works and if you can't pick up on what the article is trying to tell you then you probably shouldn't be reading it.

[MonkeyMonk]

"Since the Great Market Crash of 1929 the stock market has AVERAGED a 10% return per year."

People have been quoting this same statistic for years. Considering that the markets have lost 50% of their value in the past 18 months this statistic cannot possibly still be true. I'd actually love to see an analysis from some of the buy-and-hold index fund proponents about how index funds stack up after the big recent fall in valuation.

[bob]

FMF

nice try. Use research that actually applies and spend a bit more than 10 seconds on a rebuttal.

Jumbo CD rates?????

you tell RW to do some research, then post a link to data on Jumbo CD's, which are commonly CD's with $100K - $1 million or more, yet you use $1000 in your post as the initial example. That applies!

And Jumbo CD's eclipsed 7% exactly one time in the past two decades.

As RW said, crazy assumptions.

[rwh]

I think a lot of posters are missing the point completely. The article is about compound interest. The number isn't the point, it's the idea that CI is interest on interest and over time can be very productive.

And I had a CD from my neighborhood credit union that paid 7% as late as 2000, and I renewed it for 5 years through 2005 at 6.5%. The original value of the CD nearly doubled from 18k to 34K between 1995 to 2005. Then I put the money in the Vanguard Wellington fund. I wish I would have left it at the credit union.

And if the earlier post today on the subject of inflation is correct, we'll see high rates like that again.

[Mike Hunt]

The reason the example is so egregious is that the doubling time is so short with a 10% ROI. Using the rule of 72, the doubling time is only about 7 years. So after 7 of these doubling time periods the $6000 grows pretty darn fast. $6K, 12K, 24K, 48K, 96K, 192K, $384K, $768K. The number of doubling periods is key as if you get enough of these then you really see the 'hockey stick' come out in the exponential curve.

Realistically, houses appreciate 1% above the inflation rate, CD's about the same and stocks maybe 2-3% over the inflation rate. Now a true rate of 3% net growth corresponds to a doubling time of 24 years (using the rule of 72). That means if you want to accumulate 7 doubling periods you will need 168 years to achieve this- not possible in a lifetime. As you say, there is no such thing as getting rich quick. So don't oversell compound interest.

Also this example forgot about a big, big, big factor. Taxable interest on gains- that effectively reduces the real gain by a factor of 1/3. It's even more punishing in a high inflation environment where you get taxed just to keep up with inflation!

C'mon people- we are all taught to think critically. Apply critical thinking to this example and find the hole in the argument.

Also don't forget, there is always a small risk that the USD could bust- in that case the 60 years of savings in CD's would be for naught, wouldn't it? Time to revise the model!

-Mike

[rwh]

The fact is if I would have pulled all of my money out of the market in 1997 and stuck it in CDs at bank I would have a higher net worth today.

[FMF]

Bob --

Ok, so maybe I should have taken more than 10 seconds of research. But the comment was so off target that it got me riled.

Is anyone debating the main point -- that money invested at ANY rate -- for a long period of time is a better option of waiting and investing money at that same rate for a short period of time?

[kitty]

"Since the Great Market Crash of 1929 the stock market has AVERAGED a 10% return per year. "
Average return != compound annual return. If your stock goes up by 20% one year and goes down by 10% the next, you get average return of 10%, but real return of 0%.

One thing about simple interest. This is what corporate and municipal bonds do - they pay you simple interest twice as year as income. But... Nobody told you have to put this interest under the mattress. You can invest it in something else.

"Is anyone debating the main point -- that money invested at ANY rate -- for a long period of time is a better option of waiting and investing money at that same rate for a short period of time?"
This really depends on what the rate will be after this short period of time. A 10-year CD in 1983 locked at 13% was great. Unless you believe in 10-year deflation, I doubt it is a good idea today.

[bebe]

I read in so many books about how you should "assume your money grows 7% per year." Im in my early 20's and my money in my 401(k) and Roth IRA has gone down 50% since I began investing 2 years ago. Now the money is going going gone.