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Compounding Interest Is Powerful, Not Magic
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Compounding interest is great and I love it when personal finance experts point to it as one of the reasons why you should start saving and investing early.
What I don’t love is when experts make it seem like some sort of magical spell.
Compounding isn’t a complicated idea, but it could use some more explaining, and it’s also not perfect. Compounding works great when your money is growing, it’s less good when you’re losing money. If instead of earning 1% in interest each year, what if you lost 1% in interest each year? You’d lose less and less each year, but you’re still losing money!
So, let’s take a closer look at compounding for what it really is.
How Compounding Works
If you don’t understand how compounding works, don’t feel bad. Everyone had to learn 1 + 1 = 2 at some point in their lives and anyone who doesn’t know that shouldn’t be embarrassed. Their parents or their teachers should be embarrassed! (you can’t fault a two year old for messing up, they don’t know any better)
Compounding is simple. If you put your money in a savings account and it earns 10% each year, you understand that $100 will be worth $110 in a year. Easy.
Compounding is what happens when you leave your money in the account and it earns another 10% – this time on a larger sum. Ten percent of $110 is eleven dollars. You earn more because you have more in there. You have more in there because of the interest you earned last year. If you leave it in there for ten years, you end up around $260 because of compounding interest.
Compounding Relies on Time & Rates
Since compounding is really interest earned on interest, time is your biggest friend when it comes to compounding interest. This is especially true when the interest rate is fixed, like on a certificate of deposit, because it’s more reliable.
So the next time someone says compounding interest is the key to your financial future, just know that it’s good but it’s not magic.
{ 10 comments, please add your thoughts now! }
I agree. Like all the “rules” out there, you can really put all your faith in them just like you can’t depend on compounding interest to be your savior.
Compounding can be magical if you have lots of time. If you have $20,000 and increase it by 10% annually every year then after 159.4982 years you will have $80 billion dollars, which would make you richer than richest man carlos slim.
Well, by then, Slim will have even more money.
Compound interest isn’t magic but it is cool!
A young boy that we cared for had $1,500 in an account that needed to be taken out of his name in order to prevent parental access. We took it, put it in my name in an account with Common Sense Funds, put the paperwork in the back of the file cabinet and promptly forgot about it.
Twenty years later he learned first-hand about the value of compounding when it was cashed out for $6,000 +.
That is pretty impressive!
You should be familiar with the “Rule of 72”.
It tells you how many years it would take to double your money at various interest rates.
So at 2%, it would take 36 years.
At 6%, it is 12 years.
At 10%, it is 7.2 years.
At 18%, a mere 4 years.
Bill Snider
yes indeed! i still remember the first time i stumbled across it. so simple, yet so clever.
Pardon my ignorance, but am I to assume then that an interest that most banks are offering at 0.5% it will take me 144 years to double my investment?!
Yes, at 0.5% it’ll take that long.
Also, that’s double nominally. It’ll have lost value because of inflation.