Understanding the Power of Compound Interest

compoundingWhat I’m about to discuss is nothing new to the world of finance. The concept has been around for ages and has been discussed countless times. It won’t be earth shattering news unless you’ve never heard of it before. I’m talking about the power of compound interest.

Why would I bother writing about compound interest, or compounding, if it’s been covered many times elsewhere? It’s because compounding is one of the most vital components of both corporate and personal finance. I would be remiss if I didn’t address this oh so important subject. In fact, how could I even get away with calling this site Personal Finance Utopia if I did not have at least one post explaining what compound interest is all about and why it’s so important?

Life Without Compound Interest

If compound interest did not exist, the world would be a sad place with drastically increased poverty levels. This is because compounding, when used in your favor, can make you very wealthy. Let’s start with an example:

It’s your 10th birthday and your parents are throwing you a nice party. All your friends are there, but so is your Aunt Susie. Of course, you love Aunt Susie, but man does she embarrass the heck out of you. There’s not much you can do though when she pinches your cheeks and loudly exclaims how seemingly just yesterday she was helping to change your dirty diapers. All of your friends are snickering. You really just want her to leave the party. It doesn’t happen. In the end, it’s all worthwhile because you open up the card she gave you and inside is a crisp, brand new $100 bill. You tell her “thanks” while enduring another round of cheek pinching and then you’re finally done with Aunt Susie for the time being.

Now, what do you with that $100? You could spend it. Alternatively, you can save it. You choose the latter. If compounding did not exist, one of two things would happen with your saved money:

  • You’d stash away the $100 and nothing would happen with it.  It would just sit there…under your pillow or in a piggy bank, it really doesn’t matter. The point is the $100 stays $100. In fact, in the future it would be worth even less due to inflation, but let’s ignore that aspect for this example.
  • You decide to put your cash gift into a bank. This bank only offers simple interest on your deposit. It’s not ideal, but, hey, it’s better than just letting the $100 lay around collecting dust. The bank offers an 8% interest rate (yes, I know it’s pure craziness for a bank to be offering a savings rate that high – we’re using a “fake” world where there’s no compound interest anyway so just bear with me). After one year, the bank pays you $8 of interest earned. That’s calculated by taking the $100 x 8% interest rate = $8. After the 2nd year, you’ll get another $8 off that $100. Let’s say you leave it there until your 16th birthday when you withdraw everything to use in the purchase of a car. At that time, you’ll have $148. That amount consists of the original $100 plus $8 of earned interest for 6 years (see table below). Not too shabby, eh? But there’s something even better…

simple interest

What is Compounding?

Compounding occurs when you reinvest your earnings and those earning earn! This phenomenon allows for exponential growth of your money. Let’s get back to the $100 your Aunt Susie gave you. Alright, now this time the bank is still going to pay you that 8% interest rate, but instead it will be compounded annually. After the first year, you’ll have the same exact amount you had in the simple interest example above which was $108 (consisting of $8 of interest plus your original $100).

Year 2 is where the magic starts to happen. Instead of earning another $8 on your $100, this time the 8% interest rate will be applied to the $108 you have from year one. In other words, you’ll be earning interest on the original $100 deposit plus the $8 interest earned from Year 1. If you take $108 x 8% you get $8.64. Just like that, the power of compounding has made you an extra $0.64 in Year 2. Now, that doesn’t sound like much, but let’s take a look at what your balance would be after the 6 years of compounding:

compound interest

As you can see above, your final balance is $158.69. That’s an additional $10.69 just from compounding. Pretty neat, eh?

Extolling the Virtues of Compound Interest

You might be thinking an extra $10.69 over six years isn’t all that impressive. That amount probably wouldn’t help your car purchase out too much except for perhaps a couple of extra air fresheners. Aunt Susie only gave us $100. What if she’d given us $1,000? First, if she’d given you that much money, you’d be perfectly fine with all the cheek pinching and embarrassing stories in the world. Secondly, after that same 6 years, $1,000 compounded annually at 8% would turn into $1,587!

As you can see, with larger sums compounding can produce impressive results. Also, the more periods compounded the more you’ll end up with. If you let that same $1,000 compound annually at 8% for 50 years the end result is $46,902. If it’s compounded monthly for that same 50 years: $53,879!!

If you aren’t already doing so, take advantage of compound interest and start investing. Get your money making more money. Your Aunt Susie would be proud of you 😉

Money makes money and the money that money makes makes more money.” – Ben Franklin

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Image courtesy of FutUndBeidl at Flickr.

37 Responses to Understanding the Power of Compound Interest

  1. Untemplater March 23, 2014 at 11:24 pm #

    I remember learning about compounding in school. I remember being confused for a bit until I had that aha moment when everything clicked. That’s an awesome quote by Ben Franklin!
    Untemplater recently posted…Deciding Between A Full Time Job, Part Time, And Self EmploymentMy Profile

    • Mr. Utopia March 24, 2014 at 12:25 pm #

      I love the Ben Franklin quote as well. It’s so simplistic but yet quite profound. The quote is almost like a tongue twister too.

  2. Little House March 24, 2014 at 6:54 am #

    Compounding interest is the one reason people can actually retire if they’ve invested for 25+ years! This is really something that should be taught in school, but not many schools teach this idea. So important!
    Little House recently posted…Hard Work Finally Paid OffMy Profile

    • Mr. Utopia March 24, 2014 at 12:28 pm #

      Agreed. The math behind time value of money isn’t all the difficult (plus, there are lots of calculators out there than can help), but understanding the concept of compounding is so important. It should be taught in high school or at least made to be part of a core college course. Overall, people would be in much better financial shape if this was a mandatory lesson.

  3. DC @ Young Adult Money March 24, 2014 at 3:32 pm #

    Oh I like the spreadsheet screenshots! Haha. Compound interest is great and the time-value of money comes into play in almost every business, small to large (sorry your spreadsheet put me back in business mode – I was a finance major). It’s pretty awesome how compound interest can work in your favor and provide you with a nice nest egg for retirement.
    DC @ Young Adult Money recently posted…12 Tips for Beginner CouponersMy Profile

    • Mr. Utopia March 24, 2014 at 7:15 pm #

      I thought someone might appreciate the spreadsheets! Compound interest is exactly why people shouldn’t put off retirement saving for “some other time.” Their money won’t be making as much money that way.

  4. krantcents March 24, 2014 at 4:20 pm #

    I am the recipient of compound interest and investment growth from a very early age. It started with my down payment on my first house.
    krantcents recently posted…Do You Plan your Resume?My Profile

    • Mr. Utopia March 24, 2014 at 7:20 pm #

      I’m glad you were able to put compound interest into action at such an early age. I’m sure you can attest to its power.

  5. Daisy March 24, 2014 at 5:35 pm #

    I learned about compound interest in 11th grade math class and was instantly intrigued. I went home and talked to my mom about investing some money, but when we looked into more options for me, many investment options weren’t available to me because of my age. However, the lesson made me open my retirement savings account really early in life, which was helpful.

    • Mr. Utopia March 24, 2014 at 7:23 pm #

      Wow, that’s cool your high school taught compounding (or anything finance related for that matter). That’s unfortunate you weren’t able to take advantage and invest right away, but it sounds like you got what was most valuable out of your class – comprehending compounding’s potential. Learning that lesson at a young age is invaluable.

  6. Suburban Finance March 25, 2014 at 5:50 am #

    Compound interest can be great when you invest your money, but not so much when you borrow money haha. Love the quote!
    Suburban Finance recently posted…How To Stop Spending So Much MoneyMy Profile

    • Mr. Utopia March 25, 2014 at 8:26 am #

      Yes, that’s true. Compound interest can work for or against you. For the time being, I was just trying to get people excited on making it work for them rather than getting them depressed if it’s working against them!

  7. I didn’t start investing until my late 20’s and I really regret it. However, better late than never, right? The compounding is still in full force. Now I just have to catch up!
    [email protected] recently posted…I’ve Got Spring Fever, Do You?My Profile

    • Mr. Utopia March 25, 2014 at 10:11 am #

      Better late than never is exactly right. You can partially make up for it through better returns (ie, better investment choices) and/or continuing to save even more along the way. But, don’t delay if you don’t have to!

  8. Ryan @ Impersonal Finance March 25, 2014 at 10:41 am #

    I love compound interest. Freaking magic. I could read about it all day long. Honestly, nothing wants to make me save more than a good old fashioned chart showing what my money can turn into. And it’s definitely better to be earning the money than having someone earn the money off of you (debt)!
    Ryan @ Impersonal Finance recently posted…clothes don’t equal successMy Profile

    • Mr. Utopia March 25, 2014 at 9:50 pm #

      The charts seem to be popular! There’s nothing like a good old excel chart 😉 You’re oh so right – let compound interest work for you and not against you. It’s kind of like Star Wars where you can use the “Force” to be a Jedi or for the Dark Side!

  9. Tie the Money Knot March 25, 2014 at 1:18 pm #

    Save early, and save a lot! If these concepts on compounding (and the math) are reinforced in a younger person’s mind early on, it can make a tremendous impact on his or her financial future.
    Tie the Money Knot recently posted…Balancing Saving for Retirement and CollegeMy Profile

    • Mr. Utopia March 25, 2014 at 9:56 pm #

      I wholeheartedly agree. Parents who teach their kids the concept of compound interest are doing them a huge favor! My parents didn’t teach me about compounding per se, but they did instill the values of saving and that is pretty close. I plan to do the same for my children.

  10. David March 25, 2014 at 5:19 pm #

    Compound interest and investment growth are all me. Thanks for including an awesome article that gets to the crux of investing.
    David recently posted…Economic Impact of the Crimea Crisis on World EconomyMy Profile

    • Mr. Utopia March 25, 2014 at 9:57 pm #

      I’m glad you enjoyed it!

  11. Jen @Sprout Wealth March 26, 2014 at 5:34 am #

    You could not have explained compounding any better – simple, easy-to-understand, clear and so conversational. I hated lessons about such subjects because they were not explained in the same way. Now you got me thinking about compounding.

    • Mr. Utopia March 26, 2014 at 8:01 pm #

      Thanks, Jen. That’s what I was going for and I’m glad you think I accomplished that goal.

  12. Kay March 26, 2014 at 6:21 pm #

    Love the spreadsheets! I’m also a huge fan of compound interest! It’s something my mother taught me about when I was a kid, basically showing me how the bank would pay her to hold her money and then (the best part) they paid more interest on the interest she already earned. Free money! Of course, in this low rate environment we’re not getting such good deals saving in banks. But the concept still applies.

    • Mr. Utopia March 26, 2014 at 8:27 pm #

      You are fortunate to have had your mother teach you an important, valuable lesson at such a young age. The concept is foreign to so many people, so if you learn compounding when you’re a kid then you’ve got a huge leg up. And, you’re spot on about banks and their ridiculously low interest rates. The good news? Compounding applies to more than just savings accounts! For example, if you have a mutual fund that grows 8% one year and then that growth increases another 9% the following year there’s still compounding occurring.

  13. Peter H. March 26, 2014 at 7:38 pm #

    I wrote a post like this before, but everytime I look at the number, I see why Einstein said, compound interest is one of major discoveries of man. This concept is true for all areas of life and it’s foundational for personal finances. Doing something little everyday yielding big return later.

    • Mr. Utopia March 26, 2014 at 8:30 pm #

      Yeah, the Einstein quote on compound interest is another great one. I went with the Ben Franklin quote because it’s more fun to say (or to try to say).

  14. Robert @ The Pro Trading Futures Project March 28, 2014 at 7:16 am #

    Compounding is the key ingredients of wealth creation.
    It’s in front of all, but it is so overlooked by the majority of people, especially young adults looking for risky high return investments. In reality it is enough to put a hundred of thousand working at an average of 10%/yr and you are a millionaire in 25 years. Just 10%/yr.

    • Mr. Utopia March 28, 2014 at 1:30 pm #

      I concur – compounding is overlooked by the majority of people either because they don’t know about it or because they underestimate its importance.

  15. Syed April 2, 2014 at 6:56 am #

    Always a good idea to read a quality article about compound interest to keep motivated. When it seems inflation is outpacing our income, it’s nice to know that compound interest in our investment accounts is helping us fight back!
    Syed recently posted…The Infinite Monthly Payment LoopMy Profile

    • Mr. Utopia April 3, 2014 at 7:11 pm #

      Yes, inflation is (usually) a nasty enemy while compound interest can be a “friendly face.” That is, as long as you’re doing the investing and not going into debt. In that instance, compound interest is your enemy and inflation can actually be a good thing!

  16. Mark Ross April 7, 2014 at 5:50 am #

    I love compounding interest. It’s really amazing that it even exists in this world. Great job at defining what it is and giving out a nice example right there.
    Mark Ross recently posted…7 Fun Outdoor Activities You Can Do Without Spending Too Much MoneyMy Profile

    • Mr. Utopia April 8, 2014 at 8:28 pm #

      Thanks, Mark. I’m glad you enjoyed the example…and, no, I don’t have an Aunt Susie!

  17. DivHut May 25, 2014 at 1:38 pm #

    These types of articles really need to drive the point home to the many who really do not understand the power of compounding. Whether it’s compounding interest on a loan, savings account or the power of compounding dividends as many of the dividend growth investors already know the power of time and compounding can be immense. It always starts slow but after years and years it really starts to take off. As a dividend growth investor I remember my first dividend payments being all under a dollar, but just stick with it and watch the cents turn into dollars. Thanks for sharing!
    DivHut recently posted…My String Cheese Just Got DownsizedMy Profile

  18. DivHut July 15, 2014 at 10:10 pm #

    Such a simple concept that’s not really understood but truly powerful when given the magic of time. Thanks for sharing.
    DivHut recently posted…Around The World In Four Dividend StocksMy Profile

  19. Jenna L at Hello Suckers October 14, 2015 at 2:28 am #

    Thanks for such a clear and concise explanation.

    I was looking at my minuscule amount of annual interest that I received in my current bank account the other day, and knew that there must be a better way to build my money over time.

    Dead simple too!
    Jenna L at Hello Suckers recently posted…Equity vs. Debt in Real Estate Crowdfunding InvestmentsMy Profile

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