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The Positive Power of Compound Interest

Often when you think about compound interest, it is in the context of debt, say, a credit card’s annual percentage yield (APY) and the real cost of that loan over time. But compounding is not something that only financial institutions benefit from. In fact, when it comes to your savings strategy, compound interest (essentially lending your money to a financial institution for a period of time) can be a retirement planner’s best plan.

What is compound interest? 

Interest is a fee, usually a percentage, charged on an amount of money (the principal) over time.

Simple interest is a static amount of money charged. For example, if you are payed 5% simple interest on $100, you will make an extra $5 on that principal amount the first year and another $5 the second.

Compound interest is interest that is periodically added back into the principal (your original $100), thus increasing the amount of money you receive each year. The key to understanding the power of compound interest is to understand how things grow exponentially.

Here are two examples:

Cookie jar compound interest example 

Say you have 100 cookies on Day 1 and are told that if you don’t eat any them you will receive 10% of your total stash in additional cookies the following day to add to your cookie jar. This pattern continues every day as long as you don’t eat any of the cookies. When calculating your stash, you get to count the original 100 cookies, plus all the cookies you receive in interest.

On Day 2, having refrained from eating any cookies, you receive the additional 10 cookies (10% of 100), increasing your total amount to 110 cookies.

If you continue to hold out eating any cookies, you receive 10% of your new total (10% of 110, which is 11 cookies) on Day 3, increasing your total amount to 121 cookies.

On Day 4, your self-restraint is rewarded with 12.1 cookies, totaling your haul to a whopping 133.1 cookies!

So you can see that the longer you are able to leave your cookie jar (or your money) alone while it is earning compound interest, the benefits continue to grow exponentially.

The data drive 

Here’s another telling example of the power of exponential growth, as explained by Morgan Housel in his article “The Psychology of Money”:

“IBM made a 3.5 megabyte hard drive in the 1950s. By the 1960s, things were moving into a few dozen megabytes. By the 1970s, IBM’s Winchester drive held 70 megabytes. Then drives got exponentially smaller in size with more storage. A typical PC in the early 1990s held 200-500 megabytes.

And then … wham. Things exploded.

1999 — Apple’s iMac comes with a 6 gigabyte hard drive.

2003 — 120 gigs on the Power Mac.

2006 — 250 gigs on the new iMac.

2011— first 4 terabyte hard drive.

2017 — 60 terabyte hard drives.

Now put it together. From 1950 to 1990 we gained 296 megabytes. From 1990 through today we gained 60 million megabytes.

The punchline of compounding is never that it’s just big. It’s always—no matter how many times you study it— so big that you can barely wrap your head around it…You never get accustomed to how quickly things can grow.”

On a graph, exponential growth is that line that starts out rising slowly and quickly gains speed until the growth over time looks like the side of a skate park bowl. As it grows, its own momentum takes off.

Compound Interest graph

How can compound interest improve my savings? 

When you put your money into a savings account, you are “lending” your money out, sometimes for the convenience of having someone hold on to it, sometimes so they can lend it out or invest it themselves. The interest you receive is your reward for lending.

Just as credit card companies make more money from you the longer you keep your debt with them, the more money you will make from financial institutions when you lend your money out, untouched, over time.

What’s more, when you regularly contribute more money to a savings account (or a retirement or stock market account) on a regular basis, you further increase your eventual returns.  (One the simplest means of doing this is through automatic payroll deductions before you even see your check.)

The internet is full of helpful charts and calculators that make this point clear as day.

To take advantage of compound interest, you have to have money you can leave alone. The longer you can lend it out without touching it, the greater your returns will be when you need it. (That’s also why it’s essential to have an emergency fund or unemployment insurance to rely on should you suddenly need access to quick cash.)

Compound interest for the modern investor

Because interest builds over time, lots of financial advice emphasizes the importance of investing when you are youngideally in your 20s. That way, even relatively small amount of savings have the chance to gain momentum.

Increasingly, however, Americans are unable to follow these traditional money timelines. These days, workers in their 20s and 30s are increasingly juggling new financial strains including student loans, health care costs, and family obligations that prevent them from investing money early and/or from being able to leave their savings alone long enough to gain momentum.

Still, options for compounding your savings are available. Remember that even your bank’s savings account (as opposed to checking account) is likely a compounding vehicle. Short-term investment options such as money market accounts and certificates of deposit (CDs) offer other means of harnessing compound interest, though with penalties if you withdrawal the funds before the term is up.

It’s hard to think about putting money somewhere you cannot touch it, especially when living paycheck-to-paycheck. With compounding interest on your side, however, even a small stash can yield big returns.