05.25.2022

What is Compound Interest?

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What is Compound Interest?

You’ve heard that saving for retirement is important, and we’re sure you’ve even heard it is better to start saving early. When it comes to setting savings aside consider the phrase, “when vs. how much.” Meaning, place your focus on when to start saving rather than how much you are setting aside— every little bit adds up and it can add up quickly. But what is the logic behind saving for retirement and why does the amount you are placing aside not matter as much as the time invested? The answer is simple: compound interest!

Compound interest is defined as the addition of interest to the principal sum of a loan or deposit – or in other words, not only are you earning interest on your initial deposit but you are earning interest upon interest.

Compound Interest vs. Simple Interest 

Not all interest is treated equally, and there are different ways that interest can accumulate. The two most common forms of interest are simple or compound. Simple interest is where interest accumulates solely based on the initial principal deposit or starting amount. However, this form of interest accumulation does not earn any interest on your interest, meaning it does not compound. Compound interest, on the other hand, helps investments grow exponentially by earning interest over a set length of time. The way interest will accumulate in the account is something to consider when making savings or investment choices!

What Makes Compound Interest Powerful?

Compounding is special in the way that it works over a period time. If you were to not contribute any additional funds to your initial investment, compound interest would ensure that your money continues to grow! No matter the size of your savings, your funds will benefit from compounding. The longer you keep funds invested, the more time your money can work for you by earning additional interest.

Let’s take a look at the graph below! In this example, all participants are investing $5,000 annually at a 7% interest rate.

As shown in the graph, everyone started with an initial investment of $5,000 and continued to invest the same $5,000 annually at the same rate of 7%25. Jordan chose to invest over the course of 40 years and has a savings balance of $1,142,811 ($942,811 earned in interest) , whereas Drake invested over 30 years and has a savings balance of $602,070 ($452,070 earned in interest), and Chelsea invested for 10 years and has a savings balance of $69,081 ($19,081 earned in interest)

As shown in the graph, everyone started with an initial investment of $5,000 and continued to invest the same $5,000 annually at the same rate of 7%. Jordan chose to invest over the course of 40 years and has a savings balance of $1,142,811 ($942,811 earned in interest) , whereas Chelsea invested for 10 years and has a savings balance of $69,081 ($19,081 earned in interest) . This a great visual to articulate that it is not how much you are placing aside, but more so the length of time you are willing to invest your funds.

“Rule of 72”

Consider this— you have the funds, you are setting them aside, but at what point will your return-on-investment double? The Rule of 72 is a shortcut equation that will help determine the length of time at which your initial investment will take to double. The formula for the rule is:

Number of years to double an investment= 72/Interest Rate

For example, using Jordan from the above graph — 72/7 = 10.28 years. Just over 10 years after making her initial investment of $5000, her funds will have doubled. With that being said, it is important to note that the Rule of 72 does not take any additional funds contributed into consideration. Had Jordan not continued to invest additional funds over the course of time, this would be the outcome for her. By adding funds, she is increasing her return on investment even more.

Ready to Start Saving or Investing?

Understanding ways to capitalize your hard-earned funds can unlock your potential to live a more financially stable life. Although it is better to start early, it is never too late to start saving. Consider contacting Michigan First Credit Union for your savings and retirement options!

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