I bet you it’s not the same thing as my friend R. Get those heads out of the gutter – I’m not referring to any “50 Shades of Gray” whips and chains but to something even better…
Wait for it…
Wait for it….
Not what you were expecting, right? Not a typical go-to topic you pull out of a hat at the bar when conversation begins to dry up.
But who am I to judge? If R is into compound interest, more power to him. And if I’m being honest, I’ll admit that his excitement is warranted.
Let me bore you with a story. A few weeks ago, N and I went out on a double date with R and his wife. We were having a great time and suddenly the topic of compound interest came up. (Again I hear your sigh… were we really having that much fun if the topic of compound interest came up? Remember, new dad here. So any conversation that doesn’t involve animal noises and funny faces is a win.)
As the topic of compound interest came up, I saw R’s face light up. He pulled his chair in closer, leaned in and began to detail the importance of compound interest.
So what makes compound interest so exciting?
Potentially making a lot of money. That’s what makes the prospect of compound interest so exciting!
Compound interest, stated simply, is the concept of earning investment interest on your earned investment interest.
Let me offer a hypothetical example to better paint the picture.
If we assume you invest a hypothetical $100,000 for one year and realize a 10% return, you will have earned $10,000. Your year-end balance (assuming no distributions or withdrawals) would be $110,000.
**Insert mandatory note from compliance – This 10% is for illustrative purposes only and does not attempt to predict actual results. It is not an expected or projected rate of return, and it is possible, if not likely, that actual performance will be different from this simplified example. For this example, 10% is simply a constant factor that we can use to make a point about compound interest.**
Perfect, now that we are past Big Brother, let’s continue with our example.
In the first year, you only earn interest on your initial investment. Because there is no interest earned that is reinvested in year one, you will not earn compound interest. But if we follow the hypothetical example and add one additional year and earn the same 10% return, the annual earnings for year two would be $11,000 (assuming no distributions or withdrawals). In year two you would have earned a total of $11,000, or $1,000 more than what you would have earned the previous year.
That extra $1,000 is directly related to interest on your interest…. AKA compound interest!!!
You might ask is $1,000 really that big of a deal?
Remember, good investing is a lot about time and patience. Never more so than when leveraging compound interest.
Sure, over one year it’s “only” a thousand bucks. It’s important that we continue the hypothetical example further by extending the term for which the money remains invested. What if this money is to stay invested for 10 years, 20 years, or more with no distributions or withdrawals? What is the potential impact of compound interest over the course of many years?
- Total account value in 10 years – $259,374 (without compound interest – $200,000)
- Total account value in 20 years – $672,749 (without compound interest – $300,000)
- Total account value in 30 years – $1,744,940 (without compound interest – $400,000)
If the same investments were to earn 7% rate of return, the value in 10 years would be $196,715, in 20 years the value would be $385,968, and in 30 years it would be $761,225. The above is for illustration only and does not attempt to predict actual results.
Look at those numbers!!! I bet you want to take back rolling your eyes at my date night dinner conversation.
You can see via the hypothetical example the power of compound interest in pure numbers. Between years 10 and 20, you could have made an additional $400,000+ by keeping your money invested.
What’s even better, between years 20 and 30, you could have made over $1,000,000!!!!!
The good news is that compound interest happens automatically (assuming you do not withdraw anything). No need to sign up, re-enlist or manage your preferences. By investing and then reinvesting your money, you put yourself in a position to harness the power.
All you need to do is be patient!!!
A plan of regular investing does not assure a profit or protect against loss in a declining market. You should consider your financial ability to continue your purchase through periods of fluctuating price levels.