Power of Compounding: How It Helps Your Savings and Investments
It may seem impossible to save or invest enough money to become a millionaire.
On the surface, it seems like you’d have to save $1,000 per month for 1,000 months, or 83 and 1/3rd years, to reach this goal.
Honestly, this is unrealistic.
Thankfully, the power of compounding can help you become a millionaire in much less time if you decide to invest. Compounding also helps your savings account grow faster, but it can hurt you when it comes to some types of debt.
Here’s what you need to know to understand this powerful force that impacts your personal finances.
What is the Power of Compounding?
Compounding refers to the effect of interest earned or returns on previous interest or returns.
Compound interest is calculated using a complex formula:
- = (P(1 + i)n) - P
- P = principal
- i = annual interest rate (percentage)
- n = number of compounding periods (e.g, 10 years = 10)
- Example: $10,000 in a 5.00% APY 5-year CD
- ($10,000 (1 + 0.05)5) - $10,000 = $2,762.82 in total interest earned after 5 years
While the formula is important, an example is the easiest way to explain how compounding works.
Let’s say you have a certificate of deposit that earns 5% interest each year. This is unrealistic for a savings account, but it makes the impact easy to see. It compounds and is paid once per year.
You start with a $1,000 balance in the account and never deposit another dollar other than the interest earned. At the end of year one, 5% interest adds $50 to the account.
You now start year two with $1,050 in the account. At the end of the year, 5% interest adds $52.50 to the account. This is higher than the initial $50 interest payment because the interest you earned in year one earns interest in year two.
This is the power of compounding.
The power of compounding is even more significant when you consider the impact over years or decades.
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Here are a few real-life examples to show you the power of compounding and why finding the best interest rate you can is crucial.
Savings account with a 0.01% APY
Most major brick-and-mortar banks pay very little interest on their savings accounts. Banks offer these accounts because people expect a bank to have them.
They don’t use them to attract new customers, though, due to their substandard interest rates.
It’s easy to see why these accounts don’t attract customers. A 0.01% APY savings account adds next to nothing to your savings account balance.
If you deposit $10,000 today in a savings account earning 0.01% APY and do not add any more deposits, here’s what your balance will be in the future based on compounding interest alone:
- 5 years - $10,005
- 10 years - $10,010.01
- 15 years - $10,015.01
- 20 years - $10,020.02
- 30 years - $10,030.05
- 50 years - $10,050.13
Savings account with a 2.00% APY
Some banks use their savings account as a way to attract new customers. Most often, these are online-based high-yield savings accounts.
They pay interest rates that are often several times the national average. When you take these higher rates into account over long periods, the difference from a 0.01% APY savings account is massive.
If you deposit $10,000 today in a savings account earning 2.00% APY and do not add any more deposits, here’s what your balance will be in the future based on compounding interest alone:
- 5 years - $11,051.68
- 10 years - $12,213.96
- 15 years - $13,498.48
- 20 years - $14,918.08
- 30 years - $18,220.88
- 50 years - $27,182.06
Investment portfolio with an 8% annual return
A savings account is a good part of a financial plan. Unfortunately, a 2.00% APY won’t help you make significant progress toward larger goals, such as retirement.
Instead, you may want to start investing some of your money once you have a fully funded emergency fund.
Investment returns come with more risk and could result in you losing money. However, the average rate of return is often higher than a savings account on many types of investments.
To give you an idea about why investing is important, here’s an example showing an 8.00% annual growth rate on your investments. Compounding returns make a considerable impact in this example.
If you invest $10,000 in a mutual fund earning an 8% annual return today and do not add more money to your investments, here’s what your balance will be in the future based on compounding growth alone:
- 5 years - $14,898
- 10 years - $22,196
- 15 years - $33,069
- 20 years - $49,267
- 30 years - $109,357
- 50 years - $538,780
Reach Millionaire Status With Regular Investments
Remember how it would take over 80 years to reach millionaire status by saving $1,000 per month with no interest?
The power of compounding with a reasonable investment return greatly speeds up this process.
If you earn an 8% return each year and invest the same $1,000 per month, it’d only take you a little under 26 years to become a millionaire.
Young people with more time on their side can accomplish this same goal by investing less money over a more extended period of time.
For example, a 25-year-old could invest $300 per month. As long as they earn an 8% yearly return, they should reach millionaire status before age 65.
Does Compounding Frequency Matter?
Interest can compound daily, monthly, quarterly, or yearly depending on where you keep your savings account. The more frequently interest compounds, the more your money grows.
Each time interest is compounded, you get credit for the interest you earned. This is true even though it may not be physically deposited into your account as often as it compounds. This allows you to earn interest on your interest faster.
What’s the Difference Between Compound Interest vs. Accrued Interest?
Accrued interest differs from compound interest.
Compound interest focuses on the ability for interest to earn interest on itself over time.
Accrued interest refers to interest that has been earned but has not yet been paid.
What’s the Difference Between Compound Interest vs. Simple Interest?
Compound interest and simple interest are very different types of interest.
- Compound interest takes into account interest that may have been earned but not deposited since the last time interest has compounded.
- Simple interest is calculated only on the principal amount in an account.
Let’s say you have a savings account that earns interest at 10% a year that compounds once per month. You have $10,000 in the account at the beginning of the year. At the end of the year, you’d have $11,047.13.
If you have the same savings account that pays simple interest rather than compound interest, your ending balance would only be $11,000.
This example shows an account with interest compounded monthly pays more interest than the simple interest or annual compounding options.
Do Other Financial Terms Take Compounding Into Account?
You may wonder whether some financial terms include the power of compounding within them. Here are two of the most commonly questioned terms.
Annual percentage yield (APY)
Annual percentage yield (APY) is a term that shows the return you get after including the impact of compounding. It is calculated using the interest rate for the account along with the frequency of compounding.
Return on investment (ROI)
Return on investment shows how much an investment has changed in price over time. This does not take into account the power of compounding.
Compounding Interest Isn’t Always Your Friend
Compounding interest is excellent when you’re saving or investing money.
Unfortunately, compound interest has a darker side, as well.
When you borrow money, you may pay compound interest on your loans. This means you pay interest on the interest you already owe.
Many major loan types may not use compound interest regularly. For instance, mortgages and car loans often use simple interest.
Unfortunately, some debt types do use compound interest. Credit cards and other short-term or high-interest loans may compound interest daily.
This means you get charged for interest based on the balance on your account each day. While the interest isn’t necessarily added to your account balance daily, it’s used to calculate additional interest paid throughout the month.
To counteract this, you may want to make more frequent payments and larger payments to minimize the impact compounding will have.
Time is of the Essence
The phenomenon called compounding is a compelling concept that can help or hurt you depending on the situation.
You can use compounding to your advantage by finding a savings account that compounds interest daily and pays a high interest rate. The best option for these is often an online high-yield savings account.
The long-term effects of compounding can be outstanding, but the short-term impact may seem underwhelming. Remember, you’ll likely have some amount of money set aside for decades, so the effort is worth the benefit.
Don’t forget to do your best to prevent compounding from working against you. Be aware of the cost of compounding interest with debt, such as credit cards, by keeping balances under control.
