Have you ever thought about your retirement? Do you dream about all the things you’d do if you didn’t have to work? I do, every single day. If you want that though, then you’ll need to have a plan and work toward it. And a great place to start is to understand the power of compound interest.

This is the first post in the Personal Finance category of my site, so we’re starting out basic. If you don’t already know what compound interest is, read on to learn more about why you need to get it working for you sooner rather than later.

Let me just get one thing out of the way though: I’m not a financial advisor. I’m just a normal guy who happens to know a thing or two about money. I’m sharing my thoughts, not formal financial advice, yeah? Beauty, let’s move on!

What is Interest?

In order to understand compound interest, it helps to have a handle on normal interest first, so let’s start there. Interest is money that you earn for lending your money out to someone else, usually a financial institution.

Say, for example, you invest $1,000 in a fund with a bank. They take that $1,000 and invest it somewhere else, where they can make money off it. In exchange, they give you a small amount of interest, call it 2% per year. So at the end of the first year your money is invested, you’ll have your original $1,000, plus an extra $20 that the bank gives you for the privilege of borrowing your money.

Are you with me so far? Awesome! I’m simplifying somewhat here, but that’s the gist of it.

What is Compound Interest?

Compound interest is a fancy way of talking about money that your interest makes. Let’s take the same $1,000 we had above, but this time we’ll say you’re getting a 5% return each year. So each year, you’re getting $50 in interest?

Not quite. It’s true in the first year, but let’s say that you leave that $50 invested along with your other money. At the end of year 1, you have $1,050 invested: your original $1,000, plus $50 in interest. At the end of year 2 though, it’s a little different. You earn interest on both the original $1,000 you invested and the $50 you got from the bank at the end of year 1. So now, you’re getting $52.50 – 5% of $1,000, plus 5% of $50. This means that at the end of year 2, you’d have $1,102.50.

A Bigger Example

It seems like a small difference, but how about we play this out over 20 years, with a slightly bigger number instead? Let’s say you want to save for retirement, and you can afford to put away $5,000 each year. For argument’s sake, we’ll keep the same 5% interest rate and leave tax out of the picture. What’s the total amount you’d be investing out of your own pocket?

That’d be $5,000 per year times 20 years, so $100,000. So how much would you have at the end of 20 years with regular interest, compared to compound interest?

With regular interest, you’d get exactly $250 each year for 20 years. At the end of that timeframe, you’d have the $100,000 you put in, plus $5,000 in interest that your bank gave you, for a total of $105,000.

Okay, so what happens to the money with compound interest factored in?

Take the same yearly payment of $5,000, and now we’ll assume you’re earning interest off of your interest each year as well. How much do you think you’d have at the end of 20 years?

Well, instead of $105,000, you’d have around $165,330. Holy crap! That’s because each year your interest earns interest, and then all of that earns even more the next year, and so on. Let’s say you’re a little younger, and you have 30 years to save for retirement. How much would you have in 30 years? That number would be over $332,000 – literally double what you’d have at the end of 20 years, even though you only put in $150,000 of your own money. That’s the power of compound interest.

The Rule of 72

Ever heard of the rule of 72? Most people haven’t, but it’s a great little trick. The Rule of 72 is a shortcut for you to figure out how long it will take for an amount of money to double in value. Here’s how it works: you take the interest rate you’re getting on your money, and divide 72 by that number. The resulting figure is roughly the number of years it will take for your money to double in value.

So if we take the $1,000 and give it that 2% interest rate with compound interest, it will take roughly 72 divided by 2, or 36 years, for that money to double to $2,000. If we bump up the interest rate to 6%, it would take around 72 divided by 6, or 12 years, to double. At 8% interest, it’d be around 9 years.

Starting to get the picture? Great! We’ll leave off there for now.

Wrapping it Up

This was an introductory post to the very basics of personal finance. Like anything though, the fundamentals are important to understanding some of the finer points later on, so it’s worth starting from scratch. I’ll cover off more topics around investing in later posts. If you’re interested in reading more about compound interest though, one of my absolute favourite books on personal finance is the Wealthy Barber, by David Chilton. It’s a personal finance book told through a story about a barber and his regulars, and it’s actually a lot of fun to read (surprising, right?).

FYI, that’s an affiliate link up there, which means that if you click it and buy the book, I make a little money – call it 50 cents. It doesn’t cost you anything extra, and it helps me keep the lights on. I only ever use them when I personally stand behind whatever it is I’m linking to. If I wouldn’t use it, I don’t recommend it, bottom line!