Compound interest is one of the most powerful concepts in the realm of finance. Not convinced? Just ask Warren Buffet, one of the most successful investors who said “My wealth has come from a combination of living in America, some lucky genes, and compound interest. Let’s explore what exactly compound interest is, the importance of time value of money, and the relationship between these two concepts that allow compound interest to have the title as the eighth wonder of the world.
What is Compound Interest?
The fundamental definition of compound interest is rather simple. Compound interest is the interest calculated on the initial principal as well as on the accumulated interest of previous periods. It can be thought of as a cycle of earning interest on interest, which will quickly multiply your money.
Time Value of Money
Understanding the time value of money is fundamental when it comes to calculating the future value of money. In simple terms, this concept states that the value of money changes depending on the time at which it is invested. Basically, a certain dollar amount today is worth more than the same amount at some point in the future. This results from the impact of inflation.
Inflation and the Time Value of Money
Inflation occurs when prices rise over time, which in turn decreases the purchasing power of your dollars. In other words, the dollar you own today will buy more now than it will in the future. This is why earning a rate of return that exceeds the inflation rate is so important. We can invest that money now and earn a potential return, resulting in more money down the road.
Something to keep in mind is that over time the stock market has historically beat out inflation, so if you put the same amount of money into a savings account and investment account, the invested money will be worth much more than the money in the savings account.
What Determines Your Compound Interest Returns?
- The interest rate earned on the investment. For stock and bond investments, this means your total profit from capital gains, dividends, and interest payments. The higher the rate of return, the higher the rate of compound return.
- The length of time money remains in an investment. The longer the money sits, the more it compounds.
- Compounding frequency. This is the number of times the accumulated interest per year is paid out. Generally, the greater the number of compounding periods, the greater the amount of compound interest.
- The tax rate and the time at which it’s imposed. For example, if the investment account is an Individual Retirement Account, you don’t pay tax on interest or any profit gained from this investment account. It’s deferred until a later time in the future, which is usually at or after the age of 59 ½. Come retirement, your income tax rate should be lower as well.*
The Rule of 72
The rule of 72 is an easy way of determining just how fast your money will grow. This simple approach will determine how long your money will take to double, given a fixed rate of return.
Here’s the simple formula: 72 / interest rate = amount of years to double. You can plug in different interest rates to see in how many years your money will double. For example, If your account earns:
1%: It will take 72 years for your money to double (72 / 1)
4%: It will take 18 years for your money to double (72 / 4)
6%: It will take 12 years for your money to double (72 / 6)
8%: It will take 9 years for your money to double (72 / 8)
Compound Interest and Young Investors
The more time that an investment has to compound, the greater the potential return will be. This explains why compound interest is a pertinent concept for young investors. The sooner an investor begins saving, the more returns they’ll have come the time of retirement.
How can an Archstone Professional Help?
If you google “How to calculate compound interest”, you’ll see the mathematical formula that might give you an uncomfortable flashback to high school algebra. Don’t stress just yet. An Archstone professional will help guide you in allocating your money and help grow your investments using this very principal.
*Distributions from traditional IRAs are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS penalty.
Investment adviser representative and registered representative of, and securities and investment advisory services offered through Voya Financial Advisors, Inc. (member SIPC).
Archstone Financial is not a subsidiary of nor controlled by Voya Financial Advisors.