You’ve heard the advice time and again: Start saving ASAP so you can harness the power of compound interest. But when you have a savings account that only earns, say, 1 percent a year, you’re probably thinking, “What’s the point?”
You may not realize just how helpful compound interest can be when you’re trying to grow your money. After all, compound interest isn’t only what you earn on your principal, it’s also interest earned on interest.
It sounds like a riddle, but it’s actually a financial concept worth understanding if you’re trying to save — as well as pay down debt. Here’s a quick lesson in how compound interest works.
SIMPLE INTEREST VS. COMPOUND INTEREST
It’s easy to confuse the two, but there are some major differences. For starters, you’ll hear simple interest referenced more often with respect to borrowing money — some personal loans, auto loans and even mortgages may charge you simple interest.
Calculating how much you pay in simple interest is, well, simple: It’s the principal multiplied by the interest rate multiplied by the term of the loan. So let’s say you take out a $1,000 loan that charges you 5 percent annual interest, which you’d have to pay off in five years. At the end of the loan term, you’d have paid $250 total in interest.
Compound interest, meanwhile, is based on an exponential calculation in which interest is charged (or earned) based on the principal amount plus whatever interest has been accumulating over time (we’ll spare you the complicated math equation and just say that there are calculators for that). So using the same $1,000 example: If that 5 percent interest was compounded annually, at the end of the five years the total interest you’d pay would add up to $276.28.
So in a borrowing scenario, compound interest isn’t your friend. Ever wonder why your credit card balances seem to grow so fast? It’s because credit card companies compound the interest they charge you from month to month — which means if you carry over balances, you’re being charged interest on the previous interest you didn’t pay off (on top of whatever purchases you’ve made). Ugh.
But if you’re saving or investing, compound interest — or compound growth, if we’re talking about returns on investments — can be your best friend, particularly if you’ve got time on your side.
WHY IT’S IMPORTANT TO START SAVING EARLY
If you ever needed a carrot to dangle to kickstart your saving — especially for long-term goals like retirement — just try plugging a few numbers into a compound interest calculator. We’ll show you what we mean.
Let’s take Dave, who hasn’t thought much about saving for retirement until age 40. Suddenly, he realizes he’s got to get on the ball, and starts funneling $800 a month into his retirement account until he reaches 67. If his investments return a hypothetical 6 percent per year, by the time he’s ready to retire, he’s got $611,575 waiting for him. Not too shabby!
If you’re saving or investing, compound interest — or compound growth, if we’re talking about returns on investments — can be your best friend, particularly if you’ve got time on your side.
But now let’s look at Amanda, who decides at 30 that she’s going to start directing $500 a month to her retirement account. She earns the same hypothetical 6 percent return per year, and also contributes until age 67. When she’s ready to retire, she’s got $763,609 waiting for her.
Even though Amanda contributed less each month than Dave did, she ended up with $152,034 more in her nest egg because she got a 10-year head start on saving. And if Amanda had contributed the same $800 a month as Dave, her total would have been more than $1.2 million!
RELATED CONTENT: How much do I need for retirement? Our retirement planning guide can help you better understand the road to retirement — and how to craft a financial plan that’s built around your unique goals.
That is what we mean when we refer to the power of compound interest, and it’s precisely why you keep hearing the advice to start saving ASAP. The sooner you start, the more time your money has to grow — and the better you’ll be able to reach your nest-egg dreams.