There’s a big difference between stashing your cash under the mattress and investing it. The MVP that makes the difference is compound interest, and it can work for you (and against you) in big ways if you give it time and space.
What is compound interest?
Compound interest is the effect of “interest on interest.” When you have money invested in interest-bearing accounts (like a savings account, taxable brokerage, retirement account, etc.), you’ll earn interest on the principal amount you invest, plus interest on the interest.
Say you put your $10,000 emergency fund in a high-yield savings account, earning 1% interest that compounds monthly. Over the course of the year, you’ll receive $101 in interest, then the next year, you’ll earn interest on $10,101 instead of $10,000 and so on, allowing your money to compound, or grow, each month. At the end of five years, you’d have $10,513 as opposed to $10,500 if you were earning simple interest.
Why should you care?
Interest on interest = free money. What more could you possibly need to hear?
When you give compound interest time to work its magic, it’s making you money. It makes money while you’re sleeping, while you’re eating, and whether you’re working or on vacation.
The younger you are when you start investing, the more time your money has to compound. That means starting to set aside cash when you get your first job can actually make you far wealthier than if you wait to start saving money until later in life.
Compound interest at work
Putting savings in a Roth IRA is a great way to see how compound interest works. A Roth IRA is a tax-advantaged retirement savings vehicle that anyone with income can open. The money you put in is after-tax, and it’ll be tax-free when you remove the money in retirement.
Say you get a job at 18 and decide to max out your Roth IRA by contributing $6,000. You commit to doing that every year, and by the time you’re ready to use the money at age 60, your anticipated nest egg (assuming a 6% rate of return) has grown to around $1.1 million. (You can pause for effect here, $6,000 a year or $252,000 over 42 years for $1 million later isn’t a bad trade-off.)
Compare that to someone who decides to start maxing out a Roth IRA at age 30. They’d be looking at an estimated $500,000 in their account at age 60. Compound interest with 12 extra years more than doubled the potential investment. If that’s not enough to send you running out to invest, who knows what is.
Now what we’ve discussed so far is the impact of compound interest when it’s working for you. But what does it look like when compound interest goes from friend to foe?
Is compound interest always good?
Compound interest can apply to loans and debts too. That means the amount of money you borrow could end up costing you more the longer you take to pay it off. Let’s check out an example.
Say you rack up $5,000 in charges on your credit card to get your small business off the ground (Amazing! Go You!). But when it comes time to pay the bill at the end of the month, the cash simply doesn’t exist. The credit card company will hit you with an interest charge for carrying a balance. Then, next month, the interest you owe will be based on your original $5,000 plus the interest you were charged last month. Yikes.
The longer it takes you to repay the balance, the more interest charges you’ll accrue. The good news is you can avoid the adverse side effects of compound interest on the debt by paying the balance you owe each month, or at a minimum, paying the interest charge.
The bottom line
Compound interest can be your best friend or your worst enemy. Patience is the fuel that powers compound interest, so make it work for you by investing early and often and committing to leaving the money alone to earn for a number of years. Then, be sure to stay on top of debt payments so compound interest doesn’t work against you on the back end.