Great Pyramids of Giza, shmiza; Colossus of Rhodes, shmodes. Einstein wasn’t thinking of the ancient world for the 8th wonder of the world. No, the genius said “compound interest is the eighth wonder of the world. He who understands it…earns it, he who doesn’t…pays it.”
Compound interest is the greatest thing since sliced bread. Don’t believe me? Prepare to be amazed. Let’s say you have $1,000 that you’ve deposited into an online savings account with an annual interest rate of 2% (aka your annual rate of return). If you leave that money alone, after the 1st year, your initial $1,000 has grown to $1,020. After the 2nd year, your original $1000 has grown to $1040.40. In 2 years, you earned $40.40 without saving an additional penny – TA DA!
That 2% interest was added to the original investment (i.e., principal) and then future interest accrued on the total amount. Compound interest is the interest that accrues on an investment added to the principal and then future interest accrues on the total amount. Simply put, compound interest is interest on interest. Watch this video here to reinforce the topic.
The power of compounding makes money that is saved today more valuable than money saved tomorrow. Want to learn some math magic? To determine how quickly your savings may double, simply use the Rule of 72 (a simplified way to estimate how long an investment will take to double at a fixed annual rate) by dividing 72 by your current annual rate of return. For example, if you make a one-time investment of $7,500 today at an annual growth rate of 7.2%, based on that one year of savings will potentially grow to:
After 10 years = $15,000
After 20 years = $30,000
After 30 years = $60,000
After 40 years = $120,000
That’s a compelling reason to begin saving early in life! Here’s another:
- A 40-year-old who begins saving $6,000 a year for retirement at a hypothetical 7.2% annual rate of return in a tax-deferred savings vehicle, like an IRA or 401(k), would accumulate $452,810 by age 65.
- A 25-year-old saving the same amount at the same growth rate would accumulate $1,448,949 by age 65.
To reach the younger saver’s tax-deferred savings total, the 40-year-old would have to save about $19,200 a year—more than three times the annual savings amount of the investor who began saving at age 25.*
While the Rule of 72 is a reasonably accurate shortcut for estimating growth rates that fall in the 6% and 9% range, the higher the projected growth rate is beyond 10%, the less accurate the calculation becomes. To calculate earnings growth rates above 10%, use an online compound interest calculator or set up an appointment with Anne Simpson (email@example.com) to discuss strategies for pursuing your long-term retirement savings goals.
*Performance data provided is hypothetical; does not represent the performance of any specific investment; and assumes a 25% marginal tax bracket. Past performance is not indicative of future results.
The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. This does not represent any specific product.
This example does not reflect sales charges or other expenses that may be required for some investments. Rates of return will vary over time, particularly for long-term investments.
NOTE: the following calculator was used to derive the tax-deferred vs. taxable values in the examples above: https://www.calcxml.com/do/inv07#top