You’ve heard about it often enough, most likely when choosing a 401(k) investment, but compound interest is perhaps the smartest investment strategy one can take regardless of their investment of choice. The name of the game with compound interest is time, and the more of it you have, the bigger the payoff. That means if you’re a short-term investor, or looking to stay mostly liquid, then this strategy is most likely not best suited for you.
What is compound interest?
Compound interest is the interest you earn on interest. In short, you make an initial investment and receive a particular rate of return your first year which then multiplies year over year depending on the interest rate received.
Let’s say you make a $100 investment and receive a 7 percent rate of return (ROR) in your first year. The interest has not yet compounded as you are in the beginning stage of the investment.
But then, during the second year you net another 7 percent ROR on that same investment. This means your original $100 grows as follows:
Year 1: $100 x 1.07 = $107
Year 2: $107 x 1.07 = $114.49
The $0.49 is compounded interest earned from the first to second year, as it is interest earned on top of the initial $7 in interest earned after the first year. The $7 gained in year one is simple interest. After this initial simple interest is gained, that’s when the interest starts earning interest which is what is defined as “compounded interest.”
This might not seem like a lot, but compound interest truly takes off in long-term investment accounts.
For the sake of the example, let’s assume an account with a balance of $20,000 and an average ROR of 7 percent (10 percent is about the historical average ROR for the S&P 500 since its inception, and 7 percent can be thought of as relatively conservative.)
Year 1: $20,000 x 1.07 = $21,400
Year 2: $21,400 x 1.07 = $22,898
In two years, you will have gained almost $3,000 with $98 compound interest — simply by keeping it invested.
Using the Rule of 72 to estimate when your money will double
Over the course of a lifetime, you can double, triple, or “to the moon” your investment. An easy tool to estimate this is the Rule of 72, which is a calculation that estimates the number of years it takes to double your money at a specific rate of return. The calculation divides 72 by the rate of assumed return in order to estimate how many years it will take to double your investment.
In our above example, assuming a 7 percent ROR, you can calculate that 72 / 7 = 10.28, so it will take around 10 years to double your investment.
To maximize this strategy, …….