Back to Basics – Compounding Interest

I was talking with Ryan Guina, from the Military Wallet and Cash Money Life, and asked him for advice on writing Military in Transition. He told me, “Forrest, you have a lot of detailed articles, but some folks need to know more about the basics of finance. You should write some posts on things like compounding interest, and other basic financial principles.”

With that, Back to Basics was born (thanks Ryan!). Every once in a while, I will try to write an article that speaks to a basic concept in financial planning. So, with that said, below is my first piece on compounding interest (thanks again Ryan!)

According to urban legend, Albert Einstein once declared that compound interest is “the most powerful force in the universe.” While you can debate whether Einstein actually said it, many other prominent (and rich) people such as Warren Buffett have attributed their wealth & success to the power of compound interest. Let’s take a look at the difference between simple & compound interest, and why compound interest is so powerful.

What is Simple Interest?

It’s probably easiest to explain compound interest by first explaining what simple interest is. Simple interest is like what you would see on a savings bond. Imagine that you have a $1,000 bond, paying 6% interest. That means you would be entitled receive $60 per year for as long as you hold the bond. No more, no less.

What is Compound Interest?

According to Investopedia, compound interest is “interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.” paid out over the life of the bond. Instead of receiving the same interest each time, compound interest can be thought of “interest on interest.” There are two ways in which compound interest can profoundly impact investment results: compounding periods, and compounding over time.

Compounding Periods

While compounding periods primarily impacts results for fixed securities, such as CDs & savings bonds, it’s worth looking at this. Simply put, the more times an investment is compounded within a certain period, the more it will outperform a similar investment that is compounded less frequently. For example, a 6% CD compounded quarterly will produce better returns than a 6% compounded annually.

Let’s look at two CDs, each valued at $1,000, and each paying a 6% rate. The difference is that CD 1 pays 6%, compounded once per year, while CD 2 pays semi-annually (3% twice per year). Below is an illustration of what that small difference would look like at the end of 1 year

CD 1                                                   CD2

Year 0                   $1,000                                                $1,000

Year 1                   $1,060                                                $1,060.90

That 90 cent difference represents the fact that CD2’s second compounding period included interest on $1,030 instead of $1,000. The additional 3% of $30 gives you an extra 90 cents. Big deal, right? It only gets better over time.

Compounding Over Time

The longer you’re able to compound your returns, the more those returns will increase over time. But it’s not a linear effect. That extra 90 cents at the end of year 1 can end up being a lot more by the time you reach years 10, 20, or 50. Watch below:

                             CD 1                                                    CD2

Year 0                   $1,000                                                $1,000

Year 1                   $1,060                                                $1,060.90

Year 5                   $1,338.23                                           $1,343.92

Year 10                 $1,790.85                                           $1,806.11

Year 20                 $3,207.14                                           $3,262.04

Year 49                $17,377.50                                         $18,115.40

Year 50                $18,420.15                                         $19,218.63

Look at the difference between CDs 1 & 2 in Year 50. That extra 90 cents turned into an extra $798.48! Not only that, but the difference between Years 49 & 50 is $1,103.23. That’s more than the $1,000 we started off with! Each year afterwards, the annual interest is more than the original principal…and gets better and better the longer you stay with it.

Have you stopped wondering why rich people stay rich yet?

Barring criminal activity or doing anything stupid, the power of compound interest really manifests itself in the later years. So imagine J.D. Rockefeller, starting in 1859 with $4,000. When he died 78 years later, his fortune was worth $1.4 billion dollars, which represents a very impressive 17.78% annual return. However, if his fortune somehow passed, intact & tax-free, to an heir who managed to keep that same investment rate until today (another 78 years) that person would have over $490 trillion dollars!

Obviously, no one’s managed to do that, because a 17% investment rate is not a sustainable rate of return over the long term.  However, even managing a modest 5% interest rate would net Rockefeller’s heir about $63 billion, which would rank him among the richest people alive today. And 5% interest on that amount would be approximately $3 billion each year. Needless to say, the real power of compounding gets more obvious with each passing year…but you have to start with year 1 to get to year 50.

Stay tuned to my next Back to Basics article, where I'll discuss SGLI, its benefits, and why you may want to consider adding another policy to address your family's needs.

Forrest Baumhover is a Certified Financial Planner™ and owner of Westchase Financial Planning, a fee-only financial planning firm in Tampa, FL. As a retired naval officer, Forrest helps veterans, transitioning servicemembers and their families address the financial challenges of post-military life so they can achieve financial independence and spend more time doing the things they love.