Blog Invest How Does Compound Interest Work?

How Does Compound Interest Work?

date December 7, 2020 time 7 min read 788 views

The true secret to building wealth lies in compound interest. But how does compound interest work exactly? 

Compound interest is, simply, interest paid on accumulated interest. 

For example, if a savings account pays 5% APY, compounded monthly, you earn interest on your deposit and the interest you earned the previous month. 

As your interest accumulates, or compounds, your returns increase the longer your deposit stays in your account.

As American polymath and founding father Benjamin Franklin once said, “Money makes money. And the money that money makes, makes money.”

Money makes money. And the money that money makes, makes money - Benjamin Franklin
Money makes money. And the money that money makes, makes money – Benjamin Franklin

The magic of compounding doesn’t end with interest. You can also compound your earnings in other investments, such as stocks. Instead of cashing out your profits, you reinvest them, compounding your earnings over time. 

In an interview with Yahoo Finance’s Andy Serwer, Warren Buffett once told the story of how he turned $114 into $400,000.

“I think I bought my first stock when I was 11 years old,” Buffett recalls. “It was the first quarter of 1942– shortly after Pearl Harbor. I spent a hundred and fourteen dollars and 75 cents. Three shares- a hundred fourteen seventy-five.” 

Warren Buffett then explained how he put his then-humble earnings from shoveling snow into the S&P 500 at the time, reinvesting the dividends year after year. 

Assuming Buffett earned a little bit over 11% each year from his $114.75 from 1942 to 2018 (when the interview took place) and reinvested the profits each time, the figures checks out correctly as it turns out: his $114 had turned into $421K in 2019 and then about $468k in 2020.

(Seriously – we did the math!)

Investing and saving with compound interest is one of the simplest ways to build wealth, as you can see here in our computations
Investing and saving with compound interest is one of the simplest ways to build wealth, as you can see here in our computations

You can see that the first five, ten, or even twenty-five years doesn’t seem to make much. But pay attention how his money doubles every seven years or so. By 1977, Mr. Buffett’s $114.75 had already doubled five times, and it keeps on doubling every seven years after that.

By 2019, his money has doubled another six times; Warren Buffett’s humble earnings from shoveling snow when he was a young boy had just impressively snowballed to more than $400,000. 

And it will still keep doubling every seven years.

How does compound interest work for you?

Saving with compound interest is one of the simplest and easiest ways to use your wealth to build more wealth.

As you can see, compound interest and long-term investment work together to build wealth. 

Probably the most accessible for folks are the everyday savings, checking, money market, or CD accounts that banks typically offer. The APY – your annual percentage yield – is prominently displayed to get an idea right away of what your money can earn in a year. 

So let’s say you have a deposit of $25,000; a savings account that has a .05% APY would mean that you would earn $1,250 interest every year.

Some folks prefer to invest in the stock market or in real estate, both of which carry the potential for better earnings and carry a bit more risk. And while these are great options for investment, note that these require quite a bit more attention, maintenance, and due diligence on your part.

Coming up with a compound interest savings plan is the best way to invest
Coming up with a compound interest savings plan is the best way to invest

How does compound interest work against you?

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” 

While the internet has been trying to figure out if Albert Einstein actually said that, there’s no denying that there are two sides to compound interest. 

Yes, compound interest is the key to building wealth. But on the flipside, compound interest also works in reverse: the more debt you have buries you in an increasingly deeper financial hole.

Loans, credit card debt, student debt, etc. are costing you more money than you realize: the longer you’re in the red, the more money you’re potentially losing. 

For this reason: try to get yourself out of the vortex of debt as soon as you can. Pay off your loans with the larger interest rates first, and diligently work your way up and out so that you can finally make compound interest work in your favor instead.

Compound interest strategies for your savings you can use today

When it comes to investing, you want compound interest to work to your advantage. The guiding principle is simple: invest early, invest often, and reinvest your dividends.

The benefits of compound interest on savings and investments are simply too good to pass up. Remember: it’s not so much as the amount, but rather it’s more about time. The more time you allow your money to grow, the bigger your returns.

The best time to plant a tree was 20 years ago. The second best time to plant a tree is today
The best time to plant a tree was 20 years ago. The second best time to plant a tree is today

What you (probably) shouldn’t be investing in right now

First off: don’t let your money just sit in a bank – whether it’s a savings account, a checking account, a money market account, or a certificate of deposit (CD)– the returns just aren’t good enough to grow your money (or even outpace inflation).

The Rule of 72

The Rule of 72 is a quick way of knowing how compound interest rates affect money.

It’s an easy shortcut to approximate the effect of compound interest. All you have to do is divide the number 72 by the expected growth rate of a particular investment. The resulting number is the number of years you can expect your earnings to double.

So let’s say we’re making 15% interest.  That means we’d do 72 / 15 = 4.8 years to double.

The higher the growth rate, the shorter time it would take for your earnings to double. The more cycles you allow your money to grow, the more you ultimately make.

The Rule of 72 shows us how small increments of change to interest rates make a huge difference in earning potential, especially over the long term.

When investing, consider the interest rate and apply the Rule of 72
When investing, consider the interest rate and apply the Rule of 72

Your annual 401k contributions

Thanks to compound interest, your earnings on 401(k) contributions snowball year after year as well. The longer your contributions remain invested (decades perhaps), the more substantial your overall earnings. 

Your 401(k) contributions are practically a compound interest savings plan: so long as your funds stay in it, and the longer it stays there, the more money you can take out when you retire (many more years in the future).

Have a look at how $1,200 in annual 401(k) contributions grow over time with compound interest (with different interest rate scenarios for comparison).

Remember compound interest and long-term investment work hand-in hand
Remember: compound interest and long-term investment work hand-in hand

IDeally, you should be setting aside 10% of gross salary as retirement savings. If your company offers a matching contribution, make sure you get it all (it’s like free money!).

Investing in the stock market

Investing in just the S&P 500 can yield you some good returns. At conservative estimates of about 8% to 10% earnings per year, you should be able to double your money every seven to nine years or so). Dividend stocks are even better, as long as you keep reinvesting your earnings.

Warren Buffett is a big believer in the stock market. “The S&P 500  companies have earned well over 10% on equity – often 15% annually – for years and years and years and years.” 

He further explained that this approach has served him well over the many years he has been investing. “You get money compounding at that kind of rate underlying your investment, and…you’re going to do well.”

Investing in real estate

When it comes to real estate investments, there are a multitude of income-generating activities, but serious investors tend to do house flipping, or using the BRRRR approach to business. 

Still, coming in as an investor, it’s very possible for you to double your money every four to six years, but this obviously entails quite a lot more attention, effort, and diligence on your part.

An instant access, compounding investment?

While there are undoubtedly many ways for you to start investing or saving with compound interest, we urge you to consider opening an instant access investment account. 

This is a simple way to start taking advantage of compound interest.

  • MyConstant‘s instant access account pays you compound interest in real-time.
  • You earn 4% APY on your current balance — instant access, and you will still be able to withdraw at any time.
  • You earn interest on the amount in your balance; earnings are paid out and compounded every second.
You can begin to appreciate the benefits of compound interest on savings by signing up for a Flex account
You can begin to appreciate the benefits of compound interest on savings by signing up and depositing money into our instant access account.

At the very least, your MyConstant instant access account is better than most traditional banking institutions in terms of interest rates, allowing you to earn more (up to 50 times more than some regular savings accounts) and therefore make even more money faster.

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George Schooling

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