Albert Einstein once described compound interest as the “eighth wonder of the world,” saying, “he who understands it, earns it; he who doesn’t, pays for it.”
Compound interest is when the interest one earns on a principal balance is reinvested and generates additional interest. This concept helps accelerate the growth of money such as that in a savings account.
If one sets aside $1,000 in a savings account and earns 8% interest, the year one ending balance would be $1,080. For year two, the balance still earns 8% interest, therefore, the year two ending balance would be $1,166.4.
Examples of accounts that compound interest are savings accounts and 401(k) plans. Users of these accounts can expect a substantial increase in their balances over a period of time.
Compound interest can’t only work for savings, but investing as well. For a family of four who receives $2,400 in stimulus check money, if they were to invest the amount into a broad market index, they can expect $67,000 in 35 years based on historical average returns.
While the checks are meant to support those who are dealing with financial struggles during COVID-19, households with a stable income and healthy financial position find themselves in great position to take advantage of compound interest.
Unfortunately, compound interest can work against people with loans, such as for college tuition and credit cards payments on time. If one struggles to pay off debt on time, they may be charged a late fee. Then, if no payments are made going forward, their loan interest will compound — sometimes at a daily rate.
In addition to possible late fees, consequences can include a reduced credit score — which could affect one's future ability to take out loans — and the possibility of losing assets to repay debt.
Nevertheless, a BuzzFeed reporter Amber Jamieson described how compound interest is the path to wealth and a financially comfortable future. Speaking from experience, she advises people to start early, not worry about having a small initial investment and maximizing the length of time one holds money in a market.
“Millionaires are made in their 20’s and 30’s, not their 50’s and 60’s,” Fred Creutzer, president of Creutzer Financial Services, said, “the early bird always gets the worm.”
It might seem hard to find money to save for retirement when one’s entering the workforce, but changing spending habits could be the answer.
For instance, cutting back on coffee purchases could lead to $800,000 by retirement. What if, instead of spending $5 on a latte every morning, one invested that money and made coffee at home using much cheaper alternatives? With this approach, at the end of 50 years one could have $800,000 saved for retirement, just by switching methods of getting coffee — only one example of the many expenses people can reduce and invest for retirement instead.
Today’s education system seems to be criticized for a lack of financial literacy, as the distribution of knowledge about the topic is seemingly limited. More people should be exposed to compound interest early on, as it makes such a difference in the amount of money they’ll have at disposal come retirement.
The next time one wants to buy those brand new shoes or buy that designer brand jacket, they should think about the decision and how much that money could grow between now and retirement. For people in their 20s and 30s, the time to start investing and earning compound interest is now.
Andrew Withers is a junior finance major. Contact him at firstname.lastname@example.org.