By Cecilia T. Williams, CFP®, AIF®, Chief Operating Officer
What Is Compound Interest?
You can sum up compound interest in three words: interest earns interest. You’re taking the interest you earn on an account—whether that be a traditional savings account or an investment portfolio—and reinvesting it back into the account. By doing so, the balance keeps growing.
You’re now earning interest on your original contribution, plus your interest, year over year, as the balance accumulates.
This is a great advantage if you’re a disciplined saver and committed to adding more to your accounts over time. Even if you can’t commit to a regular deposit schedule, you can get the benefits of compounding interest if you start early and stay invested.
How Does Compound Interest Work?
Let’s say you deposit $1,000 in a savings account today with an interest rate of 5%. In one year, if you made no further deposits or withdrawals, you would earn $1,000 x 5%, which is $50. I get it—not super exciting.
But your balance is now $1,050. And if your interest rate is still 5%, you are now earning 5% on the original $1,000, plus 5% on that $50 you’ve already earned. In the next year, if you made no further deposits of withdrawals, you would earn $1,050 x 5%, which is now $52.50.
What if you stuck to the original $1,000 but continued to add $100 per month? What does that look like in 20 years? You’d be surprised – it would be about $42,000! That means you made about $17,000 in interest alone.*
Still not impressed? It may not be enough to buy that dream car yet, but the idea here is your interest is now earning money, as is your original deposit. That is the definition of compounding. And the longer the time frame you invest, the longer you have to take advantage of this compounding effect, which translates to more money earned.
In economics, they describe this as the “J Curve.” If you chart out your account value year by year, over time your balance starts to resemble the letter J: very slow earnings to start, but ramping up year by year as your balance grows. Eventually, by year 20, that compounding is earning you about $1,900 a year in interest alone. What if you add another 20 years to that timeline? Your total savings would be worth about $152,000!*
How to Calculate Compound Interest
There are so many online calculators that do the work for you. One quick and simple one can be found here: Compound Interest Calculator | Investor.gov. I would recommend changing the inputs to give yourself a realistic feel for what you could invest, and what that investment could look like in 10 to 20 years with compounding.
How Investing Early Maximizes Compounding Returns
Going back to my previous example: Let’s say you do choose to keep the money invested for another 20 years, 40 years total. In your last year, year 40, you are now earning about $7,000 a year in interest alone. And your total account value is now 3 times larger than the money you’ve contributed. The longer you can keep invested, the more it compounds—and the returns become more exponential.*
Is It Too Late For Me to Start Investing Now?
It does put a ceiling on your earnings if you start investing later in life, but it’s not too late if you haven’t started yet. While you may not have as much time to stay invested, if you’re disciplined and contributing regularly, you can still see the benefits of the compounding effect.
For those over 50, there are catch-up contributions that are allowed in retirement accounts like your IRA or 401(k)s. These allow you to contribute more than younger investors, helping you to “catch-up” and potentially add more compounding to your portfolio.
Additional Strategies to Maximize Compound Interest
If you feel like you are already set up well for the future, you can always think about compound interest in terms of gifts to others, like your children and grandchildren. A great example is the 529 plan, a tax-advantaged educational savings account. Instead of giving gifts of cash for their birthdays or holidays, if you put that money in a 529 account, those earnings have the potential to multiply your original gift amounts.
Limitations of Compound Interest
Compound interest is great, but remember, we are talking about simplistic returns based on traditional savings accounts. Those accounts’ interest rates will ebb and flow based on prevailing interest rates, and those returns may not always keep pace to cover inflation. We see this as one tool that you can use in tandem with a diversified investment portfolio and financial planning to help meet your financial goals. It should not be used in a vacuum.
Another potential pitfall? Remember that compound interest works the exact same way with debt too. If you have credit cards with high balances and you aren’t paying them off each month, the interest owed to the credit card company is added to your balances, and by the following month your total outstanding amount will be larger and continue to compound until you pay it all off! And given those rates are typically much higher than what you can earn on a savings account, it’s definitely something you should look at paying down significantly before investing.
Optimize Your Investing Strategy with Halbert Hargrove
If you’d like to learn more about how compound interest can help meet your personal goals, we’d recommended working with a Certified Financial Planner™. Our firm’s skilled professionals can help you understand where you are today—and what you can do to build your well-lived tomorrow.
Disclaimer:
*These examples are for illustrative purposes only and not indicative of any investment. Interest rates are subject to frequent change without notice. This should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives.
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This blog is provided for informational purposes only and should not be construed as personalized investment advice. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The information provided does not constitute any legal, tax or accounting advice. We recommend that you seek the advice of a qualified attorney and accountant.
