Called “The eighth wonder of the world” by Albert Einstein, compound interest is one of the greatest allies you’ll have in your financial journey – or one of your worst enemies.
In this article, you’ll learn about compound interest and the “Rule of 72”.
Put simply, let’s say you have $100 saved in your bank account, and somehow you’ve found a bank account that pays 7.2% interest (currently, 1.5% is the best out there FYI). A year from now, you’ll have $1.07.20 in your account (100 * 1.072 for those of you playing along at home…). That’s pretty cool! You just got $7.20 for doing nothing! But it gets better 🙂
The year after that, you’ll be getting 7.2% interest on $107.20, not your original $100. Two years from now that makes your initial $100 worth $114.92. That’s about $7 more again. Nothing too exciting, but you’ll notice that year 2 produced ever so slightly more money than year 1. $0.52 to be exact (107.20 * 2 = 114.40, not 114.92). That $0.52 is interest that was paid on the $7.20 that was the first year’s interest.
Now, if we keep going like this for ten years, something exciting happens. That $0.52 of “free” interest on the interest keeps growing. By year 5 you’d have $141, by year 7 you’ve got $162 , and by year 10 your initial $100 has grown to just over $200. You’ve doubled your money by doing nothing!
Not only have you doubled your money, but you’ve made 28% more money than you would have without the compounding. Remember the first years interest? It was $7.20. Now, if we just look at ten years of that, it’s only $72 (7.20*10). With compound interest, you’re worth $200 instead of $172. That $28 only happens by getting interest on top of interest, on top of interest, on top of interest. Compound interest is amazing when it works for you 🙂
That’s compound interest, and it’s also an introduction to “the rule of 72”. Money doubles every 10 years at 7.2% interest. Since it doubles every 10 years, at 20 years your $100 has turned into $400, at 30 it’s $800, and at 34+ years you have over $1000 for every $100 you started with.
That’s right. If you start saving at 20, and work until you’re 70, every $100 you save at 20 will be worth almost $3,234 by the time you retire. If you wait until 30 though, your $100 will be worth half that. That’s why it’s important to start saving as young as possible.
Now, this is a hypothetical bank account. No bank or CD has paid 7.2% as long as I’ve been alive, so you choices are really stocks and other non-insured vehicles to get a high rate like this. Fortunately, the S&P 500 has an average return of 9.7%, so even though there are ups and downs, you can easily stay on track with some smart investing. For some homework, figure out what $100 could do over 10, 20, and 30 years at 9.7%. You’ll be amazed at what just a couple percent can do when compounded 🙂