The Magic of Compound Interest

We all know about the “magic” of compound interest.  Compound interest means that, over time, you earn interest on your principal and on interest that has already accrued to your account.  It represents the time value of money.  A simple example:  if you put $100 into a 3-year CD that earns 6% per year, with compound interest, it will grow to $119.10.  At the end of year 1, your account becomes $106.00 ($100*1.06).  At the end of year 2, it grows to $112.36 ($106.00*1.06).  And at the end of year 3, your balance will be $119.10 ($112.36*1.06).  Pretty simple and not exactly a revelation.

But when you discuss compound interest over a long period of time, it has an exponential effect on the growth of your assets.  Here is an example that may be a revelation.

Supposed you contribute $2,000 per year to an IRA from ages 22 – 30.  That means over 9 years, you will be contributing $18,000.  At an interest rate of 9%, you will have $579,471 at age 65.  If, however, you start later in life and contribute $2,000 annually to an IRA from ages 31-65.  Over the course of 35 years, you have invested $70,000.  At the same 9% interest rate, you will have $470,249 at age 65.  So with $52,000 less out of pocket, you end up with over $100,000 more when you retire – all due to the effect of compound interest.  In other words, you can invest less money over less time and still come out ahead just by starting early.

Another interesting example is looking at the opportunity cost of early retirement compared to staying in the workforce a few more years.  Supposed you contribute $2,000 per year to a retirement account starting at age 22.  If the account earns a 9% rate of return, with compound interest, it grows to $673,765 by age 60 – a decent nest egg.  If, however, you defer retirement to 65 and let the ‘magic” of compound interest to take effect, your account balance will grow to $1,049,717.  That’s over $375,000 more dollars in just 5 years.

compound-interest

So, on a conceptual level, we might all know about compound interest and understand it can benefit us.  But the power of compound interest becomes truly apparent when you start projecting the numbers.  And once you run a few forecasts, I’m sure you’ll want to take advantage of the magic of compound interest.

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