What Is Compound Interest and How Can It Help Your Investments?
Today we are breaking down what compound interest is and how it can help your investments.
Please recognize while compound interest can be one of your best friends when it comes to investments and savings, it can also become a nightmare when it comes to credit cards and other debts.
So if you want to learn how to use compound interest, make it your best friend and learn about the race to $250,000, you’re going to love today’s article.
What is Compound Interest?
Compound interest is very easy to understand. So what is it? Compound interest is the interest you earn on your original money and any interest you’ve already earned. That’s why it’s such a great tool for your investment and financial plan because it allows you to grow your savings easier each year.
How Can Compound Interest Help You?
Have you ever heard the question “Would you rather have a million dollars today or a penny that doubles each day for 30 days?”
Well this is a great example of how compounding interest can help you.
As you can see by day 30 your penny that has been doubling is now worth over $5.3 million dollars!
But how?
That's the magic of compounding interest.
The Race To $250,000
What is the race to $250,000?
When your account reaches $250,000 it is the point where you can really experience the power of compounding interest.
We have been working with a couple in their 30s with this exact concept.
Let’s call them Joe and Jane.
Both work salaried jobs and are really good savers. On average we will say they are saving around $15,000/year (~$1,250/month) and have roughly $100,000 in their accounts.
Let’s say to be on the more conservative side they average ~6% in there account per year.
Once they reach $250,000 in their account the interest they will receive is ~$16,000. While they are still saving $15,000/year.
Below is a breakdown of how the portfolio and interest compare each year.
|
Years |
Portfolio Starting Value |
Contributions |
Ending Portfolio Value |
Interest Growth (6%) |
|
1 |
$100,000 |
$15,000 |
$121,900 |
$6,900 |
|
2 |
$121,900 |
$15,000 |
$145,114 |
$8,214 |
|
3 |
$145,114 |
$15,000 |
$169,721 |
$9,607 |
|
4 |
$169,721 |
$15,000 |
$195,804 |
$11,083 |
|
5 |
$195,804 |
$15,000 |
$223,452 |
$12,648 |
|
6 |
$223,452 |
$15,000 |
$252,759 |
$14,307 |
|
7 |
$252,759 |
$15,000 |
$283,825 |
$16,066 |
|
8 |
$283,825 |
$15,000 |
$316,755 |
$17,930 |
|
9 |
$316,755 |
$15,000 |
$351,660 |
$19,905 |
|
10 |
$351,660 |
$15,000 |
$388,659 |
$22,000 |
Of course there will be down markets and you will not consistently get 6% each year. However, the average diversified portfolio made up of 70% stocks and 30% bonds has average 9.21%. So as I stated earlier we did measure growth conservatively.
This example really shows the power of compound interest and why we consider it a race to $250,000.
Joe and Jane earned more interest than their annual contributions. Keeping with Joe and Jane, we extended the chart for the next 4 years.
|
11 |
$388,659 |
$15,000 |
$427,879 |
$24,220 |
|
12 |
$427,879 |
$15,000 |
$469,452 |
$26,573 |
|
13 |
$469,452 |
$15,000 |
$513,519 |
$29,067 |
|
14 |
$513,519 |
$15,000 |
$560,230 |
$31,711 |
As you can see in year 14 when the account reaches $513,000 the interest earned in the account is 2x the amount that Joe and Jane are contributing.
You work hard for the money you’ve earned, so why not make the most of it?
Action Items For Millennials & Gen X
- Look into how much interest your savings account is paying. There are many high yield savings accounts paying over 3%, which will help your emergency fund compound over time more than a traditional bank account paying you .01% interest.
- Invest early, this will allow you the most time in the market and really give your investments the compounding interest magic.
- Compound interest for credit cards and other debts work the same way. This can become overwhelming and derail your financial plan.
Until next month keep planning personal and don't leave the IRS a tip in the process!