Most people remember Albert Einstein for his expertise in the laws of physics and his theory of special relativity. But it turns out Einstein was also a genius when it comes to articulating rather mundane money matters. The white-haired wizard stated, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Fortunately, capitalizing on the power of compound interest doesn’t require a genius IQ or even a Wall Street wizard’s prowess. Yet compounded interest remains a powerful wealth accumulation tool that is frequently overlooked. Simply defined, compounded interest is interest earning interest. For example, a $100 investment in an account with a two percent annual yield would result in a $102 account balance one year later. The $2 gain may sound minuscule, but as the “interest on interest” grows, it becomes a “wonder” over time. How can a few dollars today turn into significant savings over time? Here are a few facts that make the case for this oft-overlooked wonder.
Time is on your side. The longer money compounds, the faster it grows. Money growing at six percent annually will double in about 12 years and will quadruple in 24 years!
Time and totals grow quickly. Compounded interest accelerates more quickly than you might expect. Saving $5 every month at five percent interest compounded over a 10 year period will result in $600 in savings. But the account will be worth $776 through annual compounded interest. Even if you stopped your monthly contributions, the account would grow to $1,500 in another 15 years. Skeptical? There are a number of online calculators you can use that demonstrate how compound interest works. Try the U.S. Securities and Exchange Commission calculator at https://www.investor.gov/tools/calculators/compound-interest-calculator.
Don’t be discouraged by low interest rates. Yes, banks’ CD rates remain near historically low levels, but many mutual funds average a higher return and require very low minimums to open an account. Many accounts require no management fee.
Beware the “dark side” of compound interest. Compound interest is truly a double-edge sword that is great for savers but incredibly cruel for borrowers. Credit cards and other revolving accounts use the concept of compounded interest on debt against you. That’s why paying the monthly minimum can enslave you to payments for decades. But take heart. Adding just $5 per month to a monthly credit card payment with a 14% annual percentage rate (many card rates are much higher), could avoid $1,315 in payments.
Compounded interest is an equal opportunity wonder. The beauty of compounded interest applies to all people, whether investing $10 or $10 million. Even people with very modest means can take advantage of compounded interest to reduce the amount paid to credit card companies.
Incidentally, Einstein isn’t the only American icon to have celebrated the power of compound interest. In 1790, Benjamin Franklin left $5,000 to the cities of Boston and Philadelphia to create a 200-year fund. Those in need could borrow from the fund at five percent interest and after a century, each city could withdraw $500 from the fund, leaving the rest to grow for the next century. Great minds think alike, regardless of the century. And great savings plans can begin with the power of tapping into the 8th wonder – compounded interest.