Compound Interest. Your Snowball to Financial Success

“The rich get richer.” We’ve all heard this phrase. Why does this happen? Is it better investment opportunities, access to other wealthy investors or other advantages the rest of us can’t take advantage of? Not really. Primarily, the rich get richer because of the concept of compound interest. Their money is working for them. Much like a snowball gathers more snow as it rolls downhill, money that is invested collects more and more money as time marches on. This article is a little bit of a math story problem, but please bear with me. 

This concept is not just for the rich. It can be the key to putting you on the path to financial security and success beyond your imagination. Each quarter I put a table in the newsletter comparing Bob’s and Jeff’s saving and investment history. Bob only saves and invests early for seven years and then keeps his money invested. Jeff waits for seven years and then tries to catch up by saving and investing for 13 years. At 20 years, Bob has $13,000 more than Jeff, even though he only saved $35,000 of his own money while Jeff saved $65,000.

If you are a little late to the game, like Jeff, don’t fear. You can still be much better off than many people if you start investing now. It’s never too late to get the snowball rolling. Millions of dollars could be waiting for you with only a few hundred dollars a month. Even if you don’t have a few hundred dollars a month to start, start with what you can. It’s not as easy to play catch up as you may think it is.

The Wall Street Journal reported an article written by Dr. Schlomo Benartzi, a professor and co-head of the behavioral decision-making group at UCLA’s Anderson School of Management. In the article, Dr. Benartzi illustrated a mistake many people make when calculating compound interest. Commonly, people underestimate the concept of earning interest on interest, sometimes to the tune of over $2 million. The graph below shows the actual return someone can make if they are saving $400 per month at a 10% average annual return for 40 years.

Compound interest is defined by Investopedia.com as interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan. A simple way to think about it is interest on interest. For example, if you invest $10,000 in a product that pays you a 4% return in the first year and then a 4% return again in the next year, you will not only make 4% on your initial investment in the second year but also will  make 4% on the return you made in the first year:

Year 1:    $10,000 x 0.04 = $400 (Total Earned = $400)

Year 2:   $10,000 x 0.04 = $400

                $400 x 0.04 = $16

                $400 + $16 = $416 (Total Earned = $416)

The benefit of compound interest begins in year two if you leave the returns invested. By accumulating a return on the previous return, or interest on interest, your money begins to snowball. This is when real returns begin to accumulate.

The concept of making money on our money isn’t just for the rich. Everyone can take advantage of it. So start paying yourself first and before you know it, you’ll be able to splurge on more than you thought you could.