The power of compounding
One powerful penny
If you want to wow someone with a cool math trick, start with a choice: For the next 30 days, you can either get $10,000 a day or a single penny that doubles in value each day. Anyone who chooses the penny understands the power of compounding interest, or money earning more money over time. Because while that $300,000 seems like a sweet deal, it only takes a couple of weeks for those doubling pennies to start growing very quickly. In 30 days, they would grow to a total of more than $5 million. This may be why Albert Einstein reportedly called compound interest “the most powerful force in the universe.”
Smart investing allows you to take advantage of this powerful force, helping you build your savings more quickly than you would by simply putting money away over time. Understand how compound interest works, and you can make it work for you.
Why compounding is not simple
If you have taken a loan or have debt, you may know all about how interest works when borrowing money. The same concept can help you make sense of how it grows.
Start with simple interest, which is the amount earned based on what you have to start with, known as the principal. For example, if the principal is $10,000 and you earn a simple interest rate of 10% per year, you would get $1,000 in interest.
Compound interest is based on a combination of the amount you start with plus what you earn. The money made in the first year adds to your balance, and that total informs next year’s interest. Again, if you have credit card debt, you may already know how quickly compound interest can grow. Some credit cards compound monthly, or even daily, making it more difficult to get out of debt.
Interest earning interest
How does compounding work to an investor’s advantage? In this case, if your investment of $10,000 earns 10% per year, the $1,000 you would make brings your balance to $11,000. The next year, if you earn 10% on that amount, you would earn $1,100. That is added to your balance, which increases how much you earn in the next year, and so on.
Of course, if you are investing in stocks, that rate of return is not guaranteed. Your returns may be lower, or even negative, in some years. In other years, you may see even greater gains.
The earnings can grow even more quickly if your investment is held in a tax-favored retirement account (one that isn’t taxed until you withdraw the money in retirement). Add in regular contributions and it’s easy to see why accounts like 401(k)s and individual retirement accounts can be powerful tools for saving.
Smart investing is not magic or even tricky. History shows that the longer you stay invested, the more time your potential earnings get to compound and the greater your potential growth. That’s why financial professionals often recommend that the best time to start investing is as soon as you can. It’s also a great strategy to stay invested for the long term.