GREAT BARRINGTON — To my amazement, many financial concepts are still not part of our basic education. The result is that many smart people have a misunderstanding of the immense power of compound interest. Many people don’t understand how interest rates work and can’t imagine how compounding multiplies over time.
Let’s start with the basics of interest rates. If you buy a sofa for $1,000 with a credit card with a 20% interest rate and pay it off a year later, you will have paid $1,200. It’s $1,000 for the couch and $200 for interest, or 20% of $1,000.
However, if you wait two years to pay it off, you’ll pay $1,440. This includes paying interest in the first year of $200 and compound interest in the second year of $240. Second year interest is charged on both the initial cost and the interest accrued in the first year. You can see how compounding begins to turn small interest payments into larger payments, even in a short time. That’s why you want to avoid high interest rates when borrowing and pay off your debts as soon as possible.
It’s also why you want to start investing when you’re as young as possible. Compounding becomes really powerful over decades, if not a lifetime. This is how even modest savers can become millionaires. A saver who invests $5,000 a year and earns 7% a year will have just under $1 million in 40 years, thanks to compound interest. Interest earned in the first year is only $350, or 7% of $5,000. But the interest earned in year 40 would be almost $65,000 thanks to the much higher account value in year 39.
People massively underestimate the magnitude of compound growth. Here is an example of the impact this can have. A typical domino is about 2 inches tall. If you double it you will have a 4 inch domino, double it again and you get 8 inches. How many times do you have to double this domino to get to the height of the Empire State Building which is 1,454 feet?
The answer is surprising. If you double the size of this domino by just 14 times, it would reach 2,700 feet enough to topple New York’s tallest structure with ease. The numbers are staggering.
When it comes to investing, you can expect your money to double about once every 10 years with an assumed rate of return of 7%. Over the course of 40 years, it would double almost four times, with $1 becoming about $15.
So, is a 7% rate of return on your money realistic? Can someone who saves just $5,000 a year really expect to become a millionaire? Since 1926, the average US stock market return, including dividends (S&P 500), has been just over 10% per year. There is certainly no guarantee that the future will duplicate the past, but 7% per year over the long term is not out of the question. If you put just $1 into the S&P 500 in 1926, it would be worth an incredible $8,307 at the end of last month.
Famous investor Warren Buffett is a perfect example of the power of compounding. He said: “My wealth comes from a combination of living in America, certain lucky genes and compound interest.” Buffett is said to be worth around $90 billion, which ranks him as the third richest person on the planet. But Buffett, 88, has amassed more than 90% of his fortune since he turned 60!
Buffett is said to have started saving and investing when he was 11 years old, giving him more than 75 years of funding. Buffett evidently made wise decisions from an early age and had a formidable temperament for investing and luck, to which he credits much of his success. Time, however, was critical to its success.
The power of capitalization is not an intuitive concept for most people. We should not only understand this concept, but it should be basic education for all. The earlier we learn it, the more beneficial it can be.
Luke Delorme is director of financial planning at American Investment Services in Great Barrington. He can be reached at [email protected] Past performance is not indicative of future results. This information should not be considered investment advice or a solicitation to buy securities. A professional advisor should be considered first before implementing the options presented.