The Power of Compound Interest

Feb 09, 2021

"Money makes money. And the money that money makes, makes money."

- Ben Franklin

In the age of instant gratification, day trading has drawn in many for its ability to quickly make - or lose - money.  However intoxicating and exciting that can be, investing (and saving) with a long-term horizon allows the use of compound interest power.

Overview

Compound Interest is the continual earned interest on the principal sum of a loan or deposit, or in other words - interest on interest. By reinvesting interest, rather than paying it out and spending it, the next period's interest is then earned on the now greater sum of the principal amount plus the previously accumulated interest. While focused on banking accounts, the same principle also applies to stock dividends or yield.  Simply put, your money is now earning money on money with exponential results.

Here's a great video from Sarah Nourse's YouTube Channel:

Where does Compound Interest apply?

Compound Interest applies to any investment that pays interest, dividends, or a yield. However, as a philosophy of slow, steady growth, it applies to two primary areas:

  1. Banking - Savings accounts, Certificates of Deposit, etc.
  2. Blue-chip "dividend aristocrats" - Large, stable companies with strong, dependable dividends (the stock equivalent of interest).

Either apply the same principles of "time + returns" with different risk levels (a savings account is much safer compared to even the most stable of companies). While appearing to not earn a lot compared to high-flying growth stocks, the returns can be enormous over time.  Compound interest is why it is so critical to invest early in life.

The Downside:

  1. Compounding is slow, methodical growth.
  2. Although there is never a wrong time to start long-term investing, the later you wait to get started, the less time you have to earn results.
  3. Certificates of Deposit may have slightly higher returns and restrict access to your funds for the length of the deposit.

The Upside:

  1. Moderate long term gains.
  2. Set it and forget it with auto deposits. Let your money and our economy work for you.
  3. Recession resilient. Provides ready access to funds for emergencies or investing opportunities (i.e., the ability to buy stocks after a crash)
  4. Historically beats inflations to avoid wealth erosion.

Rule of 72 - Time to double your money

The "Rule of 72" is an investing term that is a simple way to determine how long an investment will take to double.  By dividing 72 with the annual interest rate (or rate of return), you will have an estimate of how many years it will take to double.

Rate of Return Rule of 72
1% 72 years
2% 36 years
3% 24 years
5% 14.4 years
7% 10.3 years
9% 8.0 years
12% 6.0 years
25% 2.9 years

Why should I care?

The term making money in your sleep applies here. The power of compound interest is available to everyone, not just wealthy individuals.

My dad told me when I was 16 that a good starting target was to invest in a long-term growth fund with 5-10% of my monthly income each month. While I wasn't a high-earning employee back then, I invested odd job money here and there before becoming more serious and disciplined over time. Whether you can invest 1% or 100%, the main point of compound interest is to start investing young with what you can contribute consistently and if you are not young, start now!