Compound Interest: Supersize Your Investments
From the last article, Investing 101, we talked about how we invest our money to make more money. This makes our “money work for us.” One of the essential tools for accomplishing this is “interest” and it’s more powerful brother “compound interest”. Here I intend to go through basic definitions of both and show some examples including and example of how you might help to guarantee that your children are taken care of.
Interest: Your Friend
There are many ways to grow your money through investment but one thing that is common to many of these is interest. Interest (also called simple interest) is an amount of money that you are given for lending your money to someone else. For instance, if you’re given 10% interest per year on $1000 you will end the year with an extra $100 for leaving your investment where it is per year. (1000 x .10 = 100)
Compound Interest: Your Super Friend
If you leave the interest you earn in the same account as the principle (the original money) you begin to see the rewards of compound interest over time. Compound interest will make your money grow at a much faster rate. The 2 key pieces here are
- reinvesting the interest into the same investment
- letting it stay there for a period of time
Here’s how it works: As you leave your interest payments in the account with your principle, in the next year you will earn interest on the principle again, PLUS interest on last years interest payment. This is the accelerator for your money’s growth. Here’s a simple chart to show what I mean.
| Year | Principle | Interest Rate(APR) | Interest Payment |
|---|---|---|---|
| 1 | $10,000 | 10% | $1,000 |
| 2 | $11,000 | 10% | $1,100 |
| 3 | $12,100 | 10% | $1,210 |
| 4 | $13,310 | 10% | $1,331 |
If you look this table over, you’ll see that each year, the interest payment increases a little bit. Already you can see that your money is accelerating its growth but to really see the usefulness of this you have to observe it over a long period of time.
One of my favorite examples of compounding can be found in an article by Scott Burns from The Dallas Morning News where he shows how compounding interest combined with tax-free growth can provide your teen with 1 million dollars by the time they retire just by investing their income from 4 summer jobs and leaving it to grow, with no additional investment.
In his article, he uses a Roth IRA as his tax-free investment vehicle. I’d love to open one up early for my children, but this article from Kiplinger’s shows that it might be difficult to open a Roth IRA for your young child.
Another note I wanted to make about the table above. You can see that I specified APR for the Interest Rate. I wanted to keep this example simple so I used a compounding period or 1 year, but most investments are really compounded over a shorter period of time such as daily, weekly, monthly or quarterly. The effect of this is that your Annual Percentage Yield (APY) or the money that you make over a year (vs. the interest rate over a year, APR) is actually slightly higher than what you see in the table. Take a look at The Simple Dollar for a great post on the difference between APR & APY. This can help you to make decisions about which investments can be better for you.
So, while simple interest is useful for a small short-term gain in money, leaving your money to grow compounded is a much more effective way to reach your long-term goals.
