How Does Compound Interest Work?

By Jake Holmes, Financial Literacy Outreach Coordinator at the Maine Credit Union League. Reposted with permission from the Financial Literacy Blog.

How Does Compound Interest Work?

When you borrow money, whether by taking out a loan or charging your credit card, you usually have to pay it back with interest. That’s the cost of borrowing. Interest rates ultimately increase your overall spending when borrowing money—which leads to interest having a negative perception within the world of finances. However, when working in your favor, interest can be extremely valuable. In particular, compound interest can be a powerful asset when saving money for your retirement.

What is compound interest? When it comes to saving money, compound interest is the interest you earn on not only your initial contribution, but the interest earned on that initial contribution as well. It’s essentially a snowball effect. For example, let’s say you contributed $1,000 to a savings account that earns 5% annual interest. After one year, you’d earn $50, giving you a new balance of $1,050. In year two, you would earn 5% on the larger balance of $1,050 instead of the original $1,000. Your money has compounded and will continue to grow at an increasing rate each year.

To help you better visualize the power of compound interest, there are two retirement planning scenarios below. As you read through them, try to decide which of the two scenarios would earn you more money by retirement age (65-years-old).

Scenario 1 – Let’s say you’re 25-years-old and you save away $5,000 every year for 10 years, stopping when you’re 35. After that, you don’t contribute any more money and don’t touch it until you’re 65.

Scenario 2 – Let’s say you’re 35-years-old, and again, you save away $5,000 every year. Except in this scenario, you keep saving away that amount every year, for 30 years, until you reach age 65.

In both of these scenarios, your initial contribution is getting an annual return of 7%. Again, in Scenario 1, you’re saving away $5,000 a year for 10 years. That’s $50,000 that you personally added to your savings. In Scenario 2, you’re saving away $5,000 a year for 30 years. That’s $150,000 that you personally added to your savings. Which scenario do you think will ultimately result in more money in your account at age 65?
The answer is Scenario 1. You would end up with $602,070 in your account, while Scenario 2 would result in you having $540,741 in your account. This is compound interest at its finest. Even though you added less money to your savings with this option, you still ended up with more by age 65. This is because your money had more time to grow and build upon itself. Remember, your money was earning interest on not only your initial contribution, but the interest earned on your initial contribution each year. The earlier you start saving, the more time your money has to “snowball” and grow.

There are many investment vehicles available that can help you make the most of compound interest. One of the simplest starting points for building retirement savings is to contribute to your employer’s 401(k) plan if one is offered. It is an employer-sponsored, tax-advantaged retirement savings account. Alternatively, you can contribute to an IRA, which is an account set up at a financial institution that allows you to save for retirement with tax-free growth or on a tax-deferred basis. However, a simple savings account can help you prepare for the future. No matter how you choose to start saving, the important step is to start contributing as early as you can to take full advantage of compound interest.

In Summary:

Start saving for your future now. The earlier you start, the better. What if you can’t save away $5,000 a year, though? Save away whatever you can. $1,000…$500…$100. Whatever it may be, it’s never too early to start taking advantage of compound interest and setting yourself up for a healthy financial future.