The Awesome Power of Compound Interest

It is often reported that Einstein may have referred to compound interest as “the most powerful force in the universe” and “the eighth wonder of the world.” And who can argue with him?

Compound interest is interest earned on interest, or in other words adding interest to principal and earning a return on the new sum. Contrast this to simple interest, in which interest is only earned on the principal amount. When harnessed properly, compound interest can play an important role in meeting our long-term goals and can provide exponential growth on an investment.

There are a few important factors that come into play when calculating compound interest. These factors include the expected rate of return, the initial investment, and any additional investments that will be made. Another important component is how frequently the investment will compound (for example: monthly, quarterly, or annually), which is known as compounding frequency.

Perhaps the most important factor when thinking about compound interest is time. Time is what allows the value of an investment to snowball, particularly over longer periods. As an investor, the more time you’ve got the better!

$10k invested over 30 years with addition of $100/mo

The rule of 72 is a compound interest shortcut that allows us to determine roughly how long it will take for an investment to double in size. For example, using the 8% return from example above, it would take roughly 9 years for the investment to double in value (72 ÷ 8). If a more conservative portfolio is desired and a rate of return of 6% is expected, it would take about 12 years (72 ÷ 6).

This shortcut can help us think about the required rate of return for specific goals such as retirement, and how certain investment strategies and their expected rates of return could fit into achieving those goals.

“He who understands [compound interest], earns it; he who doesn’t pays it,” is another quote popularly attributed to Einstein. Perhaps with a better understanding of compound interest, we can properly understand its power and harness this awesome force towards meeting our long-term goals!

As always, please reach out to your trusted advisor with any questions.

 
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