Please enjoy this guest post from the folks at Trust Point.
Have you ever wondered why some people seem to make so much money from their savings and investments while you don’t? It could be your interest.
People with high net worth typically tend to have wealth management and financial planning teams behind them who understand the value and function of compounding interest. Without compounding interest, money in an investment or savings account doesn’t have much of a chance to grow.
Editor’s Note: If you’re completely new to investing, this might all seem like Greek to you. Our guide to investing for beginners explains how to get started in a way that you can understand. Follow the link to check it out!
Simple vs. Compounding Interest
What is compounding interest? To understand the concept, it helps to understand what it’s not. Compounding interest isn’t the same as simple interest, as US News and World Report points out. When the money in an account earns simple interest, only the initial sum you put into the account, the principal, earns interest.
In contrast, when compounding interest is an option, both the principal amount and the interest earn interest. Compounding interest allows your wealth to grow exponentially, rather than linearly. That can be the difference between enjoying a comfortable retirement or obtaining financial independence, and not doing so.
A Fun Example of Compounding Interest
Here’s a fun and simple way to visualize the difference between simple interest and compounding interest. Let’s say you want your child to do the dishes. You offer them 1 penny the first day. You then promise to double the amount you pay them for each day of doing dishes for 31 days.
Although you might be thinking that won’t be very much by the end of the month, you’d be very wrong, thanks to compound interest.
Take a look:
- Day 1 – 1 cent
- Day 2 – 2 cents
- Day 3 – 4 cents (2 x 2)
- Day 4 – 8 cents (4 x 2)
- Day 5 – 16 cents (8 x 2)
- Day 6 – 32 cents (16 x 2)
- Day 7 – 64 cents (32 x 2)
- Day 8 – $1.28 (64 x 2)
You’re still not impressed – after a full week, you’re barely paying your child more than a dollar to wash the dishes. Hold on. Because after two weeks of doubling your child’s pay each day, you end up with:
- Day 15 – $163.84
Yikes. After another week of doubling the pay for your child, you end up with:
- Day 22 – $20,971.52
This is getting to be the most expensive dishwasher ever. By the end of the month, you’ll end up paying your child:
- Day 30 – $5,368,709.12
In contrast, if you agreed to pay your child a penny a day and 100 percent interest on the principal only (that first penny), you’d only end up shelling out 2 cents a day for their dishwashing skills.
How to Make Compounding Interest Work for You
Admittedly, you’d be hard-pressed to find a bank or investment account that offers something like 100 percent compounding interest. But even an account that earns a few percentage points interest can help build your wealth and net worth in the long run.
Take this simple example. You put $2,000 into an account that earns 5 percent interest each year. At the end of the year, you earn $100 on the account. You leave that money in the account, bringing your balance up to $2,100. By the end of the second year, you’ve earned an additional $105 (5 percent of the $2,100).
Flash forward 30 years and your original $2,000 investment has earned $6,643.88, more than three times the initial amount.
Hold on, you might be thinking: I still have to wait 30 years before I can take advantage of significant earnings.
That is one of the sticking points of compounding interest – the earlier you start saving or investing, the more wealth you are likely to build over your lifetime. That’s why it’s a good idea to start building wealth and saving for retirement when you are in your 20s.
Your money will have plenty of time to grow, even if you eventually stop contributing to your savings. If you put off investing or savings until your 30s or 40s, you’ll always be playing catch-up with yourself.
One Last Thing About Compounding Interest
Here’s another thing that’s important to know about compounding interest: It can also hurt you. Just as you have the chance to earn a significant return on your investments and savings thanks to the power of compounding, so do credit card companies if you’re in debt.
That’s right, if you don’t pay your cards in full, you can wind up paying way more than the amount charged. To make things worse, many card companies compound interest daily, which means your balance can quickly balloon.
Just remember, compounding interest on a savings or investment account is a way to build wealth and become a high net-worth individual. Compounding interest on debt is a ticket to the poor house.