The Power of Compound Interest
Compound interest is often called the eighth wonder of the world - it's the process where your investment earnings generate their own earnings. Unlike simple interest which only earns on the principal, compound interest earns on principal plus accumulated interest. Over time, this creates exponential growth that can turn modest savings into substantial wealth.
The key variables are time, contribution amount, and interest rate. Starting early is crucial - $500 monthly from age 25 to 65 at 8% grows to over $1.7 million, but starting at 35 only yields $745,000. That 10-year delay costs nearly $1 million. This is why financial advisors emphasize starting retirement savings early, even with small amounts.
Compound frequency matters but less than most people think. Daily compounding versus annual compounding makes only marginal difference compared to the rate itself. Focus on finding the best return rate and maintaining consistent contributions. Tax-advantaged accounts like 401(k)s and IRAs allow compound growth without annual tax drag, significantly boosting long-term returns.
Quick Tips
- Always compare APR, not just interest rates
- Use the Rule of 72 to estimate doubling time
- Extra payments dramatically reduce total interest
Frequently Asked Questions
Simple interest earns only on the original principal. Compound interest earns on principal plus accumulated interest. Over time, compound interest grows exponentially while simple interest grows linearly.
More frequent compounding is better, but the difference is small. Daily vs. annual compounding makes maybe 0.1-0.2% difference. Focus on getting the best interest rate rather than compound frequency.
The S&P 500 has averaged about 10% annually over long periods. Conservative estimates use 7-8% accounting for inflation. Bonds return 3-5%. Savings accounts currently offer 4-5%. Diversified portfolios typically assume 6-9%.
Historically, lump sum investing outperforms about 66% of the time. However, dollar-cost averaging reduces timing risk and is easier psychologically. If you have a lump sum, invest it; if earning income, invest regularly.
Financial planners often recommend saving 15-20% of gross income. The earlier you start, the less you need to save. Use the rule of 25: multiply desired annual retirement income by 25 to get target savings.