Chances are you’ve heard of the monetary term “compound interest,” but do you know how it really works?
Otherwise, you’re in the majority: 69% of Americans don’t get it. That’s according to ValuePenguin, which asked 2,000 Americans if they could define key financial terms like credit score, net worth and compound interest, and shared the results with CNBC Make It.
This is an important concept to grasp. After all, compound interest can snowball your wealth and help you save hundreds of thousands or even millions of dollars.
What is compound interest?
Compound interest causes a sum of money to grow at a faster rate than simple interest, because in addition to earning returns on the money you invest, you also earn returns on those returns at the end of each compounding period, which can be daily, monthly, quarterly or annually.
That’s why compound interest accelerates the growth of your wealth. It’s also why you don’t have to set aside so much money to achieve your goals.
Consider the following charts from NerdWallet. Each shows how much money you would need to set aside to save $1 million by the time you turn 67. It assumes you start with zero dollars and also assumes various average annual investment returns.
The graphs are very different depending on the age at which you start saving.
Here’s what the road to $1 million looks like if you start saving at age 25:
If you start saving at age 30, things get a bit more complicated:
Here’s another compound interest chart, which New York Times columnist and author Ron Lieber says was life-changing.
Published in 1994 by USAA, it shows how much money you will accumulate over time if you invest $250 per month from different ages. It assumes an average annual investment return of 8%.
The graph shows how much money you will accumulate over time if you invest $250 per month from different ages. It assumes an average annual investment return of 8%.
If you start at age:
25: You will accumulate $878,570 at age 65
35: You will accumulate $375,073 at age 65
45: You will accumulate $148,236 at age 65
Compound interest can also work against you when it comes to loans: it means that every year or month, no matter how often your loan is, the amount you need to repay increases.
So the longer it takes to pay off your loan, the more interest you will have to pay.
For example, suppose you have a five-year loan of $20,000 with an interest rate of 5% compounded annually. A compound interest calculator shows that if you pay it off in three years, you’ll pay $3,153 in interest. But if you pay it off over five years, you’ll owe a lot more: $5,526.
How to Use Compound Interest to Your Advantage
The sooner you invest your money, the more you will benefit from compound interest. So where to invest? The easiest place to start is to contribute to your employer’s plan 401(k), a tax-advantaged retirement savings account that many companies offer, or other retirement savings accounts, such as a Roth IRA or traditional IRA.
Many experts, including Warren Buffett, recommend investing in low-cost index funds, which allow you to own a small portion of many different companies. The S&P 500, for example, is a fund that holds stocks for America’s 500 largest companies, including Apple, Google, Exxon, and Johnson & Johnson.
You can also check out robo-advisors, such as Betterment, Wealthsimple, and Wealthfront. These are automated investment services that use an algorithm to determine the right type of portfolio for your age, risk tolerance and time horizon.
No matter how you choose to invest, the most important step is to open at least one account and start contributing regularly to take full advantage of compound interest. The earlier you start, the better off you will be.
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