How Does Compound Interest Work?

Let’s take a quick walk down memory lane—to algebra class. Do you remember learning about exponential growth? You have an equation to work out, and then you map a curved line on some graph paper. It starts out low and gradual, but when it finally takes off, it skyrockets! 

If I’m sounding like Charlie Brown’s teacher right now (wa-waa-waa-waaa), hang with me. Exponential growth explains how compound interest works, and—if you use it right—this powerful formula could make you millions of dollars. I bet you’re tracking with me now!  

So, let’s jump right in: What is compound interest and how does it work?  

What Is Compound Interest?

Compound interest is earning interest on top of interest. When you invest money, you’re expecting to get a return on your money, meaning that you should end up with more money than you originally put in. If you leave that money alone (the initial principal plus the interest), compound interest applies the interest rate to the total new amount of money earned, so that it builds exponentially over time.  

An image of this quote: Compound interest is earning interest on top of interest. It's like a mathematical explosion!

Simple interest, on the other hand, does not accrue (fancy investing talk for build up over time). Once you pay (or earn) interest for a particular period, it’s gone. It’s not added to the next payment period the way compound interest is. 

Compound interest is the secret sauce for building wealth, and it’s one of the most basic principles of investing. If you want to build wealth, you have to get out of debt (paying interest) and start investing (earning interest).

How Does Compound Interest Work?

Compound interest is like a snowball that’s rolling downhill. As it picks up momentum over time, it gets bigger and bigger. Here’s an example:

Let’s say you invest $1,000, and—just to keep it simple—it earns 10% a year in interest. After one year, you’d have $1,100—the original money plus $100 interest that you earned. The second year, you’d have slightly more—$1,210—because you’re earning interest on top of interest. The investment compounds, or builds up, over time. Now $1,210 doesn’t seem like a big deal at first, but it becomes a big deal later. If we leave that $1,000 alone for 40 years, and it compounds annually at 10%, it will grow to a sum of over $53,000! And all you put in was $1,000!

The number of compounding periods will determine how quickly your investment grows. Interest can be compounded daily, weekly or yearly.

Compound Annual Growth Rate (CAGR)

Compound Annual Growth Rate is an important investment concept that’s related to compound interest. It’s a way to measure the growth rate of your investments over time. When you’re investing to save for retirement, you should put your money in mutual funds. Mutual funds don’t earn a fixed interest rate. In fact, the value of a mutual fund can rise and fall. That’s why it’s important to choose mutual funds with a long history of strong returns.

When I estimate the overall growth of my mutual fund investments, I like to use the long-term growth rate of the S&P 500. The S&P 500 is a common measuring stick for how the stock market is performing. And since I invest in good, growth stock mutual funds (and you should too), I expect my mutual funds to keep up with market performance.

The Power of Compounding

To help you see the power of compounding in action, I want to tell you a story about Jack and Blake—two guys who got serious about investing for retirement. They picked good, growth stock mutual funds that average an annual return of about 11.6%—just under the long-term growth rate of the S&P 500.

Jack

  • Starts investing at age 21
  • Invests $2,400 every year
  • Stops contributing money at age 30
  • Total amount contributed: $21,600

Blake

  • Starts investing at age 30
  • Invests $2,400 every year
  • Contributes money until age 67 (a total of 37 years!)
  • Total amount contributed: $91,200

At age 67, Jack’s investment has grown to $2,547,150, and Blake’s has grown to $1,483,033! Nine years made a difference of over one million dollars.

An image shows an illustrated graph of Jack and Blake's investments growing over time.

So, while mutual fund investments don’t earn compound interest, they do experience compound growth—and as you can see, it works the same way! The secret sauce for harnessing the power of compound interest is time. The number of compounding periods is what makes your interest explode.

Compound Interest Formula

All right, math nerds, it’s your time to shine. Here’s how you calculate compound interest:

A = P(1+r/n)nt

  • P is the principal (starting amount)
  • r is the interest rate
  • n is the number of times the interest compounds each year
  • t is the total number of years your money is invested
  • A is your final amount

If you’re experiencing terrifying flashbacks to school days when you had to memorize math formulas for a test, don’t worry. We’ve got an investment calculator that will do the calculations for you.

How to Grow Your Investments With Compound Interest

The combination of compound interest (or growth) and time is the key to investing. But it won’t make you rich overnight. It’s all about having the right mindset. Stay focused for the long haul. Be disciplined. It will pay off in the end!

An image of the quote: Interest that you pay is a penalty; interest that you earn is a reward.

Remember: Interest that you pay is a penalty. Interest that you earn is a reward. Here are four key strategies to get your money working for you in compound interest:

1. Get out of debt.

Compound interest is a powerful force. You want it to work for you, not against you. If you’re in debt, you might be making compounding interest payments on a credit card. That’s why it feels like drowning—because the amount you owe keeps increasing. Avoid debt like the plague. Check out the debt snowball for a proven plan to destroy your debt—for good.

2. Start as soon as possible.

Remember Jack and Blake? The more compounding periods your money experiences, the larger it will grow. Start investing in growth stock mutual funds (either through your workplace retirement plan or a Roth IRA) as soon as you can.

3. Increase your contributions each year.

If you get a raise this year, earn some money through a side hustle, or come into some money through an inheritance, increase your contributions instead of increasing your standard of living. You should invest at least 15% of your income in retirement, and there are ways to invest more than 15% as your earnings increase. It will be worth it when you watch your investments explode.

4. Exercise patience.

Have a long-term mindset. The key to harnessing the power of compound interest is to leave your money alone for an extended amount of time. For the first few years, it might feel like nothing’s happening. But remember that exponential growth graph we talked about earlier? The longer you let it be, the higher it grows!  

It’s great to save money and build wealth, but what’s it all for? The whole point of understanding the power of compound interest is to be able to invest and reach your high definition retirement dreams. If you haven’t started planning for your financial future, check out my Retire Inspired Quotient (R:IQ) calculator. It’s a free tool that shows you exactly how much you need to invest every month so you can get compound interest working for you.

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