The Power of Compound Interest
It’s easy to place investing on the mental back burner. Sometimes short-term goals are a more immediate focus—or perhaps the concept of investing feels distant, something that people earlier in their careers think they’ll get to later.
While this kind of thinking is understandable, it’s this mindset that may cause investors to miss out on the life-changing benefit of compound interest.
What is compound interest?
Compound interest is the interest on a deposit (or a loan) that’s calculated based on the amount of money initially deposited (or loaned) … and the previous interest that you’ve earned. Simply put: It’s interest on interest. It’s the gift that keeps on giving.
Let’s take a quick look at two different scenarios to show how compound interest works:
- Late-Start Lucy begins investing at age 35 in an account earning her 6.25% per year and stops when she retires at age 65. Over those 30 years, she’s able to invest $72,000. Her ending portfolio is about $210,000
- Ten-Year Tim starts early and invests from ages 25 to 35 in an account earning him 6.25%. Over that time, he’s able to invest $24,000. However, then, he stops. Thirty years later, his ending portfolio is about $209,000.
Ten-Year Tim invested significantly less than Late-Start Lucy, and for a much shorter period of time, but due to the power of compound interest, ends up with almost the same amount of savings as her at retirement!
How can I take advantage of compound interest?
Now that you know a little more about what compound interest is and how it works, consider the following actions to start making the power of compound interest work for you!
- For starters, you may wish to make sure that you’re paying down any debt you may have as strategically as possible. The first step in making compound interest work for you is to make sure it isn’t working against you. It may make sense to pay down credit cards, student loans, and other forms of borrowing.
- Spend as much time being invested as possible. In our example above, Ten-Year Tim’s money was invested for 10 more years than Late-Start Lucy’s, which provided more time for his money to compound.
- The largest benefits of compound interest come in the latest years. Being in a position where you need to sell your investments earlier than planned could stop the snowball effect of compound interest. Have a plan in place to account for your short-term goals so that your long-term investments can work for you for as long as possible.
- Prioritize investments in accounts that leverage compound interest. It’s important to keep some cash in a savings account for your Emergency Fund and other upcoming cash needs but beyond that, brokerage accounts, IRAs, or 401(k)s may be good options; your financial advisor will be able to look at your portfolio and determine the best options for you.
Compound interest is powerful, but the secret ingredient truly is patience and the passage of time. The true trick to taking advantage of compounding interest is to start early and give your funds time to compound and grow.
If you’ve been asking yourself “what is compound interest” or “how does it work”, we hope this article helped! But, if you’re looking for more nuanced insights and advice, the team at Commas is always here to provide support. If you’re interested in getting started with investing to harness the power of compound interest, reach out to our team today!
Commas is a wholly-owned subsidiary of Truepoint Inc., a fee-only Registered Investment Adviser (RIA). Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A and Form CRS filed with the SEC, can be found at www.usecommas.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice.