The Wonder of Compound Interest

A true understanding of compound interest can be a game changer for a personal-finance novice. This small concept is one of the most powerful tools for making and retaining wealth—or, if you aren’t careful, sinking deep into debt. If you haven’t grasped this concept yet, then it’s time you did.

How Compound Interest Works

There are two main types of interest: simple and compound.

Simple interest occurs when the interest earned only applies to the original amount year after year. With compound, you earn interest on your interest.

Let’s break it down. You just invested $4,000, and it earned 8 percent in the market in its first two years

With simple interest, you earned:

• Year 1: $320 = $4,320
• Year 2: $320 = $4,640

With compound interest, you earned:

• Year 1: $320 = $4,320
• Year 2: $345.60 = $4,665.60

See the difference? In the second year of compound, you earned interest on $4,320 instead of $4,000. This may seem like an insignificant amount of money, but given time, it’s easy to see why saving early and often is what builds a strong nest egg.

The Biggest Advantage

Understanding the difference between compound and simple interest isn’t the key to a healthy balance sheet, however. You need to use the biggest tool in your financial kit: time. The younger you are, the more time you have to get interest working in your favor.

Want an example?

Cailin is a 23-year-old who recently opened an individual retirement account (IRA). Imagine she never deposits another dime after contributing the annual maximum of $5,500. If the money has an average 7 percent return, then in 36 years—when she can make her first withdrawal without a penalty—she’ll have $62,831.68.

But what if Cailin didn’t put $5,500 into an IRA until she was 30? Thanks to the seven-year delay, she would have $39,128.41 when she turned 59. If she waited another five years, she’d only see $27,898.02 in her account.

Time is your best friend when it comes to taking advantage of compound interest.

Don’t Get on Interest’s Wrong Side

Anyone who has experienced credit card debt understands how interest can be devastating when it works against you. Sinking into debt can feel impossible to recover from because interest keeps your lender happy—but makes your life miserable. It’s important that you stay on the right side of compound interest by having it work in your favor.

Another Way to Save Money

One simple way to save money is to move to a state with no state income tax. A single, 25-year-old in North Carolina earning $60,000 could save $3,898 per year by moving to Austin, Texas. If that money is invested annually and receives an average of 6 percent interest, it means an extra $685,767 for retirement by age 67. Even just putting the one-time savings of $3,898 in an IRA receiving 6 percent interest until retirement at 67 would earn you an additional $45,049.31.

Investing early and consistently is one of the keys to wealth. As Albert Einstein said, “Compound interest is the eight wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

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