What Is Compound Interest?
When it comes to investing, compound interest really is the most powerful force in the universe. Remarkable in both its simplicity and its power, compound interest is the concept of reinvesting, along with the original principal sum, the interest earned on your investment.
As a result, you earn interest on top of interest, and then more on top of that larger sum, and so on. "Over time, a small amount of money can become a mountain of money," says David Winters, CEO of Wintergreen Advisers.
Compound interest is one of the most basic concepts for investors to understand, in no small part because its magical results work the same whether you have $100 or $100 million.
[See: 7 Tips for Finding the Best Target-Date Retirement Funds to Buy.]
In that sense, it's every investor's secret weapon -- and you probably want to use your secret weapon if it can help you build your retirement nest egg (which it can). Unfortunately, if you look at how the average American spends and invests, it doesn't reflect a great respect or understanding of compound interest.
It's time to change that.
Proving its power in a thought experiment. David Reiss, professor of law at Brooklyn Law School, likes to convey the profound power of compound interest with a riddle of sorts.
"Would you rather receive a gift on Jan. 1 of $1 million, or a penny that doubles every day for the rest of the month?" Reiss says. "Most kids would go for the million bucks, but those who are patient enough to do the math know that they can get millions more if they are patient enough to wait the month."
It's true. The penny-doubler would in fact finish January with $9.7 million more than his or her instant gratification-seeking friend.
The rule of 72. Using one shorthand trick, the rule of 72, you can figure out how many years it will take to double your money, assuming a certain rate of return. Simply divide 72 by your expected annual rate of return, and you'll have your answer.
Therefore, if you expect to earn 10 percent interest on your investment, it'll take roughly 7.2 years to double your money. (In practice, it will take 7.3 years). This can also show the power of compound interest; if you didn't reinvest the interest every year, it would take 10 years to double your money at a 10 percent rate of return.
Practical implications: start investing early. Even more interesting than the math behind it are the practical implications for investors. One of the more important takeaways is the idea that you should start investing early.
Starting early has a dramatic impact when you leave your returns in your investment. Consider someone who has amassed a $10,000 nest egg in the stock market by age 25. If they never contribute another penny in their life, and the market earns 8 percent a year, they'll retire at age 65 with $217,245.21.
[See: 7 of the Best Cheap Stocks to Buy Under $10.]
If, however, a 35-year-old starts saving with $10,000 in the stock market, it will only become $100,626.57 by the time retirement comes around.
"The most important decision an individual makes with respect to investing is the decision to start," says Bob Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania. "Time is the greatest ally of the investor, as time allows for compounding."
Might people be a little more prudent about saving if they kept this concept forever in mind? It's hard to imagine the answer is "no."
Fees eat into returns over time. Another takeaway from realizing the power of compound interest is that fees -- on exchange-traded funds, mutual funds, money managers, etc. -- cost you a lot more than just the charge itself. That money could've otherwise been reinvested in the market and compounded into a small fortune.
At a 10 percent rate of return for 50 years, $10,000 turns into $750,025.36 if you assume your manager is charging an annual fee of 0.9 percent. The same investment at the same rate of return but with a 0.05 percent fee -- some Vanguard index funds offer low rates like these -- would turn into $1,144,931.78.
That's a difference of about $400,000. With that in mind, investors should really keep a keen eye on the expense ratios and management fees they're shelling out to the people and institutions handling their money.
"High fees over many years can really cut into your earnings," Reiss says. No kidding.
Pay off your credit cards. Would you want a force as powerful as compound interest working against you? The answer is clearly no, but still many millions of Americans carry large outstanding balances on their credit cards. Compound interest is the reason many stay perpetually in debt due to these bills.
Mastercard (ticker: MA), Visa ( V), American Express ( AXP) -- these are companies that traffic in and profit from the magical ability of interest to compound upon itself with remarkable results.
It's no coincidence that one of Warren Buffett's biggest investments is AXP -- it's a way for him to wager more money on compound interest, the concept that thrusts Wall Street skyward.
Time to put it to use. Compound interest is precisely how Buffett became a billionaire to begin with, and how he's managed to perennially grace the list of the richest people on earth for decades now. If you'd have invested $10,000 in Berkshire Hathaway ( BRK.A, BRK.B) in 1965 and let it ride, it would be worth $197.27 million today.
But thankfully, you don't have to work with big sums to make it work -- anyone can utilize it to their advantage.
Using this secret weapon we're all equipped with truly has the potential to solve the financial anxieties of millions of people, if only they practiced a bit more patience and discipline.
[See: 7 of the Best ETFs to Own in 2017.]
It's not easy to sock away money every month in a low-cost index fund you can't touch for decades, and denying yourself that flat-screen TV you've been pining for is easier said than done. But if you want to use your secret weapon to reach your financial dreams, you've just read the instruction manual.
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