How to Harness the 'Miracle" of Compound Interest
Albert Einstein is often credited as describing compound interest as the eighth wonder of the world. While there’s some debate over whether he actually said this, one thing’s for sure: the effect compound interest can have on savings can be truly wondrous.
When you’re saving over the long term (typically for retirement), compound interest really comes into its own. Over decades, your total interest earned can make up the vast majority of your overall savings. Let’s take a look at how compound interest works and why it pays to start saving early.
How Compound Interest Works
Compound interest occurs when you earn interest on the interest your savings have already earned. For example, let’s say you save $1,000 for a year at 10% interest. At the end of that year, your savings have grown to $1,100 — $1,000 is the principal (your original savings amount) and $100 is interest.
The second year, interest is earned on the whole $1,100 and your savings then grow by $110 to make a total of $1,210. This continues every year until the interest you make far outweighs your original investment.
How your compounding interest is calculated can have a big impact on how quickly your savings grow — and this depends on your bank or investment company. Let’s take a look.
Compound Interest Schedules and Periods
Interest can be compounded at any frequency, from daily to annually. The more frequent the compounding schedule, the faster your money grows. This is because the interest is added to the principal more frequently, so interest is paid on the higher amount more often. Daily or monthly compounding schedules will grow interest much faster than annual compounding schedules.
The compounding period is also important. If you save for forty years, the power of compounding really builds up in the last 10 years, whereas in the first 10 years it’s a much less significant amount. Let’s look at an example to show you how miraculous compound interest can be.
A Compound Interest Case Study
Sara is 25 and is wondering when to start saving for her retirement, which she expects to happen in 40 years, at age 65. She starts off with a $300 investment and is committed to saving $300 every month ($3,600 per year) until she retires.
Sara intends to invest in mutual funds (collections of stock market shares) and she expects her investments to benefit from average annual returns of 8% (this is a realistic figure when investing in stocks, given that the S&P 500 has delivered annual returns of 10.51% since 1971).1
Sara talks to her financial advisor, who provides her with this table of potential savings, based on monthly compounding, with total savings depending on the age she starts to save:2
|Age began investing||Years of Investing||Savings at 65||Interest earned|
Sara’s advisor also tells her that if she invests in a Tax-Free Savings Account (TFSA), all the interest earned will be tax free. You can find out more about TFSAs in our article, “What is a TFSA?”
Not surprisingly, Sara decides to start saving immediately. Thanks to the miracle of compound interest, if she starts saving now instead of waiting until she’s 35, she could save more than double the amount of money by the time she retires.
If Sara waited until she was 55, the magic of compound interest would have almost passed her by. At 55, to save the same amount of money by age 65 as her 25-year-old self, she would have to save almost $6,000 per month.
Even if Sara had just invested $10,000 at age 25 and didn’t add to it, with an average annual return of 8%, by age 65 it would have grown to $242,734.
How To Get Started
A Cornerstone financial advisor can help you set up the right investment account for you that can benefit from compound interest. They can also help you to set up automatic payments, so your savings grow even faster, without you even having to think about them. Call us on 1.855.875.2255 to set up a meeting.
1 The S&P 500 Index tracks shares in 500 of the largest American companies. Growth data as per Forbes Advisor’s Average Stock Market Return.
2 Calculations as per the OSC’s compound interest calculator.