Compound Interest: The Magic Snowball That Grows and Grows
Compound interest is the eighth wonder of the world, or so the saying goes. It is the mechanism by which your money earns money, and then that earned money earns money of its own. Over time, the effect becomes exponential.
Key sources: "The Little Book of Common Sense Investing" by John Bogle, "The Intelligent Investor" by Benjamin Graham.
How It Works
Imagine you invest $1,000 at a 10% annual return.
- Year 1: $1,000 + $100 = $1,100
- Year 2: $1,100 + $110 = $1,210
- Year 3: $1,210 + $121 = $1,331
Each year, the interest grows because it is calculated on a larger base. This is compound interest in action.
The Rule of 72
To estimate how long it takes for your money to double, divide 72 by the annual interest rate.
At a 10% return, your money doubles in approximately 7.2 years. At 6%, it takes about 12 years.
Why Starting Early Matters
Two people save $5,000 per year at an 8% return.
- Sarah starts at age 25 and saves for 10 years. Total contribution: $50,000.
- Tom starts at age 35 and saves for 30 years. Total contribution: $150,000.
At age 65, Sarah has approximately $787,000. Tom has approximately $611,000.
Sarah invested less money but started earlier. Compound interest did the rest.
Key Takeaways
- Start now. Time is your biggest advantage.
- Be consistent. Small regular contributions outperform large irregular ones.
- Reinvest your earnings. Do not withdraw the interest.
- Be patient. Compound interest is unremarkable at first and explosive over time.