Jul 21, 2010

The Magic of Compound Interest (Carole)

When you are investing money, there are two basic types of interest your money can earn:  Simple Interest and Compound Interest.

Quickly, let's look at the difference between these.

Simple Interest 
(Interest is only calculated on the money you have invested):  
If you invest $10,000 (your principal) at 5% interest for 20 years:
$10,000 x 5% x 20 years = $10,000 (interest earned) 
Add this interest earned to your original $10,000
$10,000  + $10,000  = $20,000

Compound Interest 
(Interest is calculated on your invested money PLUS your previously earned interest):
If you invest $10,000 (your principal) at 5% interest for 20 years with compound interest  you'll end up with $26,532.98 .   

The formula is a bit complex and hard for me to type out, but you can look it up here if you just really need to see it for yourself.

In addition:
The more often  your compound is calculated (daily, monthly, yearly) the more interest you will earn.  Daily Interest = $27,180.96
Monthly Interest = $27,126.40
Yearly Interest = $26,532.98

The longer your money is invested the more interest you'll earn.  Your same $10,000 at 5% for 30 years turns into $43,219.42   Same money, same interest for 40 years is $70,399.89

The higher your interest rate, the more interest you'll earn.  Your same $10,000 at 10% for 20 years will become $67,275.00

Combine longer time and higher interest and it starts to get really fun:
$10,000 at 10% for 30 years =  $174,494.02
$10,000 at 10% for 40 years =  $452,592.56

$10,000 at 12% for 20 years =   $96,462.93
$10,000 at 12% for 30 years = $299,599.22
$10,000 at 12% for 40 years = $930,509.70  (yep, nearly a million $)

Imagine if you could scrape together only $10,000 by age 20 and find a good mutual fund that paid 12% interest (not that difficult really) and just LEFT YOUR MONEY THERE until you were 65 years old, you would have $1,639,876.04   That's without you ever adding one more cent of principal to this investment.  The sooner you can get investing in something earning a decent interest rate, the better off you will be at retirement.

That is magic.  If you want to work some magic yourself, here is a compound interest calculator.  I'll warn you -- it's addictive!

P.S.  Your mortgage (or car payment, student loan, credit card bill. . .) works on a compound interest formula in your lender's favor.  That is why you often end up paying 3 times the cost of your house by the time your loan is completed.


Packrat said...

I sure wish this would be taught in high school. I think in some classes it might be touched upon, but I don't think it is fully explained why it is so important to know.

Thanks for the link.

Heather said...

Could you also do a post about how you go about finding a mutual fund and what a mutual fund actually is? Thanks.