Compounding interest is a powerful concept that can significantly improve your investment returns.

Compounding interest gives an investment the opportunity to increase exponentially, because your
money earns interest both on the principal and on the prior interest payments. Stated another way,
the interest you earn is calculated not only on the amount of money you invested, but also on the
accumulated interest your money generates over time. So you’re making money both on the money
you worked hard for, and also on the interest earned in your past returns.

In this topic we will help you understand the general concept of compounding interest, teach you a
way to determine how quickly your money will double, and provide practical tips so you can take
advantage of this opportunity.

Compounding interest requires two key ingredients: the reinvestment of your earnings, and time.

Understanding Compounding Interest

Time is one of most important factors that determine the benefits you receive. The younger you are
when you start getting compounding interest working in your favor, the bigger your advantage.
However, people of all ages can benefit from compounding interest. To illustrate how important time
is, consider this example: if someone 20 years old starts investing $200 per month and earns an
above-average return of 8%, that money has potential to turn into a million dollars by the time the
person reaches age 65. But if the same person waited until they were 30 to invest, and then put in
$200 per month, even at the same 8% return that person’s nest egg would reach only just over
$462,000.

Reinvestment of your earnings basically means not taking any money out of your investment account.
So you are reinvesting all earned interest, dividends, or capital gains back into your investments. By
doing so, you now generate returns from your past returns. For example, let’s say you invested
$1,000 and earned a high interest rate of 10%. The first year you would have made $100. By keeping
that $100 in the investment (e.g. not pulling it out at profit) you would be reinvesting those earnings
of $100. So now you would have $1,100 invested. Your return at the end of the second year would be
$110. At the end of the third year you would see a return of $121. Reinvesting creates a snowball
effect where your money multiplies at faster and faster rates.

Now, of course, by keeping your earnings invested, you are subjecting it to the same risk as your
original investment experiences. In our example, we are consistently earning 10% three years in a
row. This rate is not common, nor is any gain ever guaranteed. To achieve such a high return rate, you
would have to subject your investments to higher risk of loss.

Let’s use a short mental exercise to illustrate the power of compounding interest:

Would you rather have $100,000 now or 1 penny that doubles every day for 1 full month?

Due to compounding interest, doubling a penny every day will turn into $5,368,709.12 after 30 days!

Clearly, this example is not possible in an investment situation – it would mean getting a 100% ROI
every day! But it does show how even small beginnings can grow dramatically over time due to the
power of compounding interest.

High-interest Debt & Investments

So far we have been talking about how compounding interest can work in your favor. This powerful
force also can work against you. If you owe money – on credit cards, taxes, or other loans –
compounding interest is taking you farther away from your financial goals. Every billing period, unpaid
interest on your debts is added to the principal amount you owe. Then, the following billing period,
you will pay interest plus the unpaid interest from the previous billing cycle.

Fixed-payment debts such as mortgages or vehicle loans, where the payment remains the same
across the full term of the loan, are calculated so that interest is paid every billing cycle. Some of your
payment goes toward paying interest, and the remainder goes toward paying down the principal
balance. However, making only the minimum payment on credit card debt is a prime example of how
you can end up paying interest on interest – month after month – without ever really putting a dent in
the principal amount you owe.

The negative effect of compounding interest is the reason why it is critical to pay down unsecured
high-interest debt before you start investing. If you pay 25% interest on credit card debt while earning
just 5% on your investments, you are at a net negative ROI of 20%. The money you invested would be
better spent paying down the high-interest debt. Your investments would have to earn greater than
25% ROI to justify investing the money rather than using it to pay down the high-interest debt.
Consider that 25% is a VERY high ROI, is extremely unlikely, and, in the event it did happen, probably
could not be sustained month after month. Bottom line: pay down high-interest debt before you
invest.

Calculating Compound Interest with a Calculator

Get your calculator handy, because you will be learning to calculate how compounding interest can
affect your finances. This simple activity will help you understand how compound interest works.

You invest $10,000 that earns a return of 5%* per year. At the end of one year, you will have made
$500:

$10,000 X .05 = $500

This figure is how much you earned.

If you reinvested these profits, you would just add your earnings to your original investment:

$10,000 + $500 = $10,500

Alternatively, if you intend to reinvest your earnings, you can simply add 1 to your expected return
rate like so:

$10,000 X 1.05 = $10,500.

This calculation combines the 2-step process shown above into a single step.

*Note: 5% is used for hypothetical purposes; your investment returns may make more or less than
that percentage.

The previous example shows how to calculate your return over a single period of time (1 year in our
example). But what about interest that compounds year after year?

Year 1: $10,000 X 1.05 = $10,500.00

Year 2: $10,500 X 1.05 = $11,025.00

Year 3: $11,025 X 1.05 = $11,576.25 … and so on.

This is a very simple, but tedious way of calculating compounding interest. Furthermore, it assumes
that interest compounds only once per year. More accurate calculations can be made using more data
and more math if you so choose. We’ll “up the math” here for additional education, but don’t worry if
it seems too complicated. The basic idea of compounding interest, as we showed previously, is the
key concept to understand.

To be clear: you do need to understand the following equation to successfully understand

investments, interest rates, or return on investments. This equation is more complex and provides
additional accuracy, but it will not make or break your future financial plans.

To calculate compounding interest in a single mathematical equation, you would use this formula:

Where:

A = future value of the investment (the dollar amount of your total investment: original principal plus
all interest earned)

P = principal investment amount (the original amount you invested)

r = annual interest rate (expressed in decimal form: 5% would be 0.05)

n = number of times interest is compounded in a year (“1” if compounded annually; “12” if

compounded monthly; etc.)

t = number of years of your investment

Example: You invest $10,000 that earns a return of 5% per year, compounded monthly (12 times a
year) and keep the investment active for 3 years:

Alternatively, you can just use an online compound interest calculator.

The Rule of 72
The Rule of 72 says that if you divide 72 by the non-decimal interest rate (that is, 10 rather than 0.1)
you receive on an investment, the answer tells you how many years it will take for that money to
double. The Rule of 72 helps illustrate that the earlier you start saving for retirement, the better the
chances that your money will double.

Examples:

If you have $10,000 in savings and are earning a 10% interest rate, your money will double in 7.2
years. 72 / 10 = 7.2

If you have $10,000 in savings and are earning a 5% interest rate, your money will double in 14.4
years.
72 / 10 = 7.2

If you have $10,000 in savings and are earning a 2% interest rate, your money will double in 36 years.
72 / 2 = 36

Conclusion
Understanding how compounding interest works represents another important step on the path
toward preparing to invest. Compound interest on investments works in your favor by giving your
investment an opportunity to increase at higher rates, because you earn interest both on the principal
you invested plus the interest you earned on the principal. Compound interest works against you
when you carry high-interest debt, like credit card balances. Once you understand how compounding
interest can benefit your financial plan, you are one step closer to getting ready to start investing your
money.

Activity: Compound Interest Calculator & Goals Activity

This activity asks you to set three goals you would like to achieve in the future, estimate the total cost
of each goal, and then calculate the amount of principal you would need to invest to reach your goal
in each scenario.

Start Activity