Posted by Michelle Lamb on January 31, 2020
Ever heard that “compound interest is the most powerful force in the universe”? Compared to other forces like instinct or imagination, I’m not so sure… but it certainly rings true in personal finance.
Wait, what does “compound interest” mean again?
What I tell my children is “simple interest” is when someone pays you a certain amount of cents to borrow your dollar. “Compound interest” means they agree to pay the same percentage on the new cents too – the ones THEY had paid you. For example, simple interest of 2% on $1,000 for 40 years results in $1,800 ($20 per year times 40, plus your money back). But with compound interest you would earn $2,208.04 – an extra $408.04.
The power of compound growth can get remarkable the higher the percentage. A common hypothetical is “What if someone offered you one million dollars OR one penny doubled every day for 30 days?” The results may surprise you.
Granted, doubling is rare in investing – some even say the best way to double your money is to fold it and put it back in your pocket! But even with a rate like 7%, compounding can work “mathemagic”. For example, if you save the maximum in a 401(k) retirement account ($19,500 allowed in 2020) each year for 40 working years (ages 25 to 65) and invested at a 7% compound growth rate, your investment of $780,000 turns into almost $3.9 million.
A powerful force to keep in mind as you stay patient building your own wealth!