What Is Compound Interest?
“Compound interest is the 8th wonder of the world. He who understands it…earns it. He who doesn’t…pays it”
One of the most famous sayings out there is “there is no such thing as a free lunch”. Essentially, you can not expect anything to be handed to you without giving something in return. For the overwhelming majority of situations, this saying rings true. However, there is at least one exception to this rule.
In the world of finance, compound interest offers an incredibly rare “free lunch”. If you use compound interest effectively then you could wind up with significantly more money with hardly any additional work on your end. Again, without putting in any additional work, compound interest will grow your net worth.
This article will discuss what compound interest is, how you can use it to your advantage, and some of the best ways to generate it.
Compound interest defined
If you are not familiar, interest is simply the cost of using someone else’s money. Most people are familiar with interest because they are required to pay it when they borrow money. For example, if you have outstanding student loans then you most likely make monthly payments. When you make this payment, you are usually paying a combination of both the principal (the amount you borrowed) plus some interest.
Compound interest is defined as the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. In other words, compound interest is the interest that your interest earns.
However, what some people might not realise is that compound interest is also something that can work in their favour. Instead of constantly paying interest to other people, you can use your own money to generate interest for you. Any time you lend or invest money, you have the potential to earn compound interest.
Warren Buffet’s favourite way to describe compound interest is to imagine a small snowball at the top of a very long hill. If you push the snowball down the hill it will start to roll down the hill and collect more snow. As it collects more snow, it will grow larger. As the snowball grows larger, it will have more surface area which allows it to collect snow at an even faster rate and grow even larger.
Compound interest works in a very similar way. Imagine that you put money in a savings account. At the end of one year, you will have earned interest and your savings account will be larger than the previous year. The following year, you will earn more interest because your savings account is a little bit larger than the year before. In year two you earn interest on your initial savings amount plus interest on the interest you earned from year one. This is how your money starts working for you. As this process continues, your savings account will grow at a larger rate each year (just like the snowball).
To get a better idea of how this works, let’s take a look at two different examples.
Saving without compound interest
John works hard and puts $10,000 aside and keeps it under his mattress. He does this at the end of every year. After 20 years, he has accumulated $200,000.
Saving with compound interest
John works hard and invests $10,000 into an investment that earns 10% compound interest. At the end of year 1, he earns $1000 interest. His total is now $11000. At the end of the first year, he invests a further $10,000 and does this every consecutive year. In year 2 he has invested a total of $20,000 but earns interest on $21000, his interest is then $2100. So the process continues and after 20 years he has invested $200,000 but has earned $216,654 in interest. His total amount is $416,654.
How can I use it?
In short, you use compound interest to your benefit by not withdrawing from your savings and letting the snowball grow bigger and bigger. Put your savings for the long term aside and just let it grow. Once you take some of your money out you greatly reduce the compounding effect, putting you years further back. This means not withdrawing money. Stay invested for the long term and keep investing is the golden rule.
On the flip side, another way to use compound interest is to recognise when it is not working in your favour. Eg when you have a student loan or credit card debt, you have that same snowball rolling down the hill but this time it is on the money you owe. If you leave your debts to grow interest then eventually that snowball becomes too large and you cannot do anything to stop it. You find yourself in a position where the interest that builds up in your debt is more than you can afford to pay off each month. Golden rule. Get rid of bad debts (debt with high interest) as soon as you can, it will save you a lot of money over the long term.
Just like in the previous example, compound interest is a tool that will allow your savings or retirement account to grow exponentially instead of linearly. If you understand and take advantage of compounding then you can retire with significantly more money without having to work any harder.
Without compound interest, your account will only grow when you add money to it (just like John in the first example). This is what your savings account growth will look like if you do not use compound interest:
Something to consider: universally wherever you leave your money in the bank or in bond or anywhere it earns compound interest automatically, but at a much lower rate than you could potentially earn. People rarely keep their retirement savings under the mattress or in the freezer. Sure, for a small holiday people keep money in a drawer or somewhere but very rarely for their life savings. Usually, the argument we have for clients is to not put your money in the bank and earn less than inflation(which eats away the value of your savings), instead invest it and earn a solid return (can be conservative but at the very least beat inflation). The two extremes, in reality, are usually money in the bank vs investing savings.
In the first scenario, your savings account will grow only when you decide to add money to it. There is nothing wrong with this type of growth because it still means that you are consistently contributing money to your account.
However, if you are trying to save for retirement or simply grow your net worth then there is a much better way to do it.
If you keep your money in a place where it can collect interest and compound on itself, then it will grow like this:
In this second scenario, your money can grow at a rate faster than what you put in each month because it is also earning interest each year. As your savings gets bigger, you will earn more in interest which will allow it to grow even faster. This will ultimately result in more money for you for the same amount of work.
As Albert Einstein said at the beginning of this article, those who understand compound interest, earn it. Now that we have covered what compound interest is and how you can use it, let’s take a look at some of the best places to earn it.
Best places to earn compound interest
Compound interest can be earned almost anywhere that you can invest money. A few of the most common places to reliably earn interest on your money:
- High-yield savings accounts – These have become more popular in recent years and are essentially just regular savings accounts that offer a higher interest rate to attract customers. These accounts usually pay an interest rate that is 20-25 times the national average of a standard savings account. This can make a tremendous difference over time. Not a good place to earn interest. We advise all our clients to not keep money in the bank. Invest it
For example, if you kept $10,000 in a savings account that pays the industry standard (.10 APY) you would earn just $10 at the end of the year. However, if you put that $10,000 in a high-yield account that earns 2% (2% is less than inflation, in this account, you lose purchasing power every year) then you’d earn $200.
2. High-yield checking account – Although these are much harder to come by, some checking accounts also offer high rates of interest. This means that your cash will be earning money as it is waiting to get spent. Same story as the first option
3. Fixed income securities (bonds) – Bonds are another reliable place to earn compound interest and grow your wealth. When you buy a bond, you are essentially loaning your money to a government or corporation. In return, you receive a bond which is an official document that means they will repay you in the long-term (usually 5-12 years). Usually 3-25 years In the short-term, they will also send you payments semi-annually. (bonds have different coupon dates and rates, semiannual is an example of a bond, not all bonds are semi-annual)
4. Stocks – A stock is a share of ownership in a public corporation. When you own a stock, you can share in the success of that company and will benefit (note: not to be confused with earning profits) if the price of that stock increases. You also can earn money in the form of dividends, if the company chooses to pay them.
5. CDs (Certificates of deposit) – These are products offered by banks and credit unions that provide customers with an interest rate premium. In exchange for the higher rate of interest, the customer agrees to leave a lump-sum deposit untouched for a predetermined period of time.
One thing to note is that almost all of these options come with varying degrees of risk. Due to this fact, to determine what is the right answer, you will have to consider things like your financial situation, your risk tolerance, investing horizon, and goals. Together with a financial adviser, these can be determined and that will determine which mix of the above examples are best suited to your situation.
Now that you know about the power of compound investing, you will be able to use it to your advantage.
We hope that you have found this article valuable when it comes to understanding what compound interest is and how you can benefit from it.