This excerpt is taken from Dollar Scholar, the Money newsletter where managing editor Julia Glum provides essential modern money lessons that you absolutely need to understand. Don’t miss out on the next issue! Sign up at money.com/subscribe and become part of our thriving community of over 160,000 Scholars.
The terms money and magic are seldom used together, unless one is discussing the impressive net worth of illusionists like David Copperfield or the fascinating concept of compound interest.
While I can’t provide insights on the magician’s finances, the topic of compound interest comes up with astonishing regularity in my interviews. In fact, I just conducted a search for the term “compound interest” on Money’s website, and it appears in over 230 articles published since 2012.
Experts often describe compound interest as a kind of “magic.” Legend has it that even the renowned physicist Albert Einstein was an admirer, famously stating, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
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Understanding Compound Interest: The Key to Wealth Building
I reached out to Julie Guntrip, a financial wellness expert at Jenius Bank, to gain more insight. She began by defining compound interest: “Compound interest is when the interest earned on a balance is calculated not only on the original principal amount but also on interest that has already accrued,” Guntrip explains in an email.
Essentially, compound interest enables me to earn interest on my interest, creating a powerful financial snowball that continues to grow over time.
“It may feel like magic due to its exponential growth potential,” she notes. “What begins as a modest increase can significantly amplify over many years if left to accumulate, effectively allowing your money to work for you on autopilot.”
Consider this example: Suppose I deposit $1,000 into a savings account that offers a 5% interest rate annually. By the end of the first year, my balance will increase to $1,050.
However, in the following year, I won’t just earn another $50; instead, I will earn 5% on the new total, leading to an interest of $52.50. This amount is then added to my existing balance, resulting in a total of $1,102.50 at the end of year two. As this process continues into the third year, my balance grows to $1,157.63, and so forth.
If I keep my funds untouched, after a decade, I will have approximately $1,628.89. After 20 years, my total will reach approximately $2,653.30, and after 30 years, my balance will soar to around $4,321.94 — more than quadrupling my initial investment.
I will have effectively multiplied my money four times without any additional effort on my part.
The numbers become even more striking if I start with a larger initial deposit. For example, a $50,000 deposit with a 5% annual compounding interest rate will grow to $52,500 after one year, and after 30 years, it will balloon to an astonishing $216,097.12.
Guntrip emphasizes that time plays a crucial role in this process, making it particularly advantageous for younger individuals to leverage compound interest. The longer someone has to allow their account to accumulate compound interest, the more substantial their financial growth becomes. This is why financial experts strongly encourage individuals to start saving as early as possible, even if only with a minimal amount.
I can find opportunities to benefit from compound interest in various types of accounts, including high-yield savings accounts, certificates of deposit (CDs), and money market accounts. According to Experian, I can also maximize my gains from compound interest by reinvesting earnings from dividend stocks, exchange-traded funds, mutual funds, and more.
If you’re interested in the mathematical side, the formula for calculating compound interest is A = P (1 + r/n)⁽ⁿᵗ⁾. Here, P represents the principal, r is the interest rate (expressed as a decimal), t indicates the time period, n is the number of times interest compounds, and A signifies the total amount earned at the end of the specified time period.
While the mathematics might be complex, one doesn’t need to possess Einstein-like intelligence to appreciate the advantages of compound interest. Guntrip points out that it is particularly significant in retirement accounts such as 401(k)s and IRAs, which individuals often maintain for several decades. This means literal decades of accumulating interest on an ever-growing balance. The benefits become even more pronounced if I contribute to the principal amount over time.
Can you see why “magical” might be an appropriate description now?
However, it’s important to note that compound interest isn’t always a positive factor. While it can significantly enhance my savings over time, it can also work against me if I find myself in debt, as Guntrip cautions.
For instance, credit card interest compounds daily, which means that any outstanding balance can escalate quickly. If I have a $10,000 credit card balance with a 20% annual percentage rate (APR), that 20% divided by 365 days results in a daily rate of approximately 0.05479%. After just one day without payment, my balance would increase to $10,005.479. The next day, interest is calculated again on this higher total, resulting in an additional charge of about $5.482, bringing my total to $10,010.961.
Although these small increments may seem negligible, they accumulate rapidly. By the end of the month, my initial $10,000 debt could exceed $10,151.
“The ‘magic’ can turn into a financial burden if payments aren’t managed diligently,” warns Guntrip.
Maximizing the Benefits of Compound Interest for Your Financial Future
The allure of compound interest lies in its capacity to generate interest on a continually increasing balance that grows larger over time. Financial legends like Einstein, Benjamin Franklin, and Warren Buffett are correct: This phenomenon is truly remarkable, and it’s essential to leverage it while I’m still young.
My future self will undoubtedly express gratitude for my wise financial decisions today.
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