Compounding is the way your money grows on its own, and it’s the main reason to start saving as soon as you possibly can. Time is your best friend when it comes to compounding, and longer time means a lot more money. That’s especially true for long-term savings, like retirement savings. People who wait until their forties or fifties to start saving will have to put away much more than those who began in their twenties.
Compounding
To illustrate the true power of compounding, assume you invest $1,000 at 5 percent interest compounded annually. After ten years, you’d have $1,646. At the twenty-year mark, your account would be worth $2,712. And after forty years, you’d have $7,358. That extra $6,358 is your money working harder for you.
There are two basic methods of calculating interest: simple interest and compound interest. Simple interest accrues (accumulates) only on your initial investment. For example, if you have $1,000 that earns 5 percent simple interest annually, every year your account would grow by $50. With compounding interest, you earn interest on your investment plus the interest it’s already earned. For example, if you have $1,000 that earns 5 percent interest compounded annually, you’d earn $50 ($1,000 × 0.05) the first year. The second year, you’d earn interest on your new balance of $1,050, so your interest for the year would come to $52.50 ($1,050 × 0.05). Every year you’d earn interest on interest, helping your money grow that much faster. The effect that compounding can have over a long period of time is astounding, especially with larger initial investments and higher rates of return.
Earnings on saving and investment accounts usually compound annually, quarterly, or monthly. The more frequently compounding takes place, the faster your money will grow. Let’s say you put $5,000 in an account that earns 10 percent interest. Here’s what your investment would be worth at the end of ten years based on different compounding intervals (and this is without you adding in any more money):
To illustrate the effect of a longer period of time on compounding, consider Bill, who contributed $2,000 at 6 percent interest to an IRA beginning at the age of twenty-two and continued doing so each year until he was thirty-nine. By the time he was sixty-five, his $34,000 investment had grown to nearly $362,000. His friend Jim made a $2,000 contribution every year for thirty-five years, for a total of $70,000, but because he started at the age of thirty-one, his nest egg totaled only about $180,000. Even though he contributed much more than Bill ($70,000 versus Bill’s $34,000), he ended up with around 50 percent less money.
The rule of 72 is a nifty mathematical computation you can use to estimate how long it will take a certain sum of money to double at a certain interest rate (assuming the interest is compounded annually).
To calculate how quickly your investment will double, divide 72 by the interest rate or expected rate of return (for earnings other than interest, such as dividends or capital gains). The result is the number of years it will take your money to double, assuming you reinvest your earnings. So if your money is returning 8 percent annually, you make the following quick calculation: 72 ÷ 8 = 9. This means it will take approximately nine years for your initial investment to double.
You can also use the rule of 72 to estimate what rate of return you’d need to earn in order for your money to double in a certain number of years; for example, ten years: 72 ÷ 10 = 7.2, so you’d need to earn 7.2 percent annually for your money to double in ten years.
As you can see, the real growth comes after the money has doubled several times. By using the rule of 72, you can calculate how much you’ll have by a certain time, and you can compare the long-term effects of interest rates on various investments that you own.
You can use the rule of 72 to see how long it will take your credit card or other debt to double too. If you have a $5,000 credit card balance with an interest rate of 10 percent, your debt will double in 7.2 years if you make no payments and no additional charges. If the interest rate is 19 percent, your debt will double in 3.8 years. You can see why it’s so hard to pay off your credit card debt, especially if the interest rate is high.