We have all heard that compound interest can help us become wealthy. Even Albert Einstein knew this when he famously said:
“Compound interest is the 8th wonder of the world. He who understands it, earns it . . . he who doesn’t . . . pays it.”
But unless you remember the lessons from your high school Algebra classes, you may not really understand how compound interest works.
Don’t worry, I’m here for you! Not only will this article help you to understand exactly how compound interest works, but it will also show you the power of compound interest by using a few examples.
First . . . a formula
The following formula is used the calculate the future value, A, of any investment:
A = P · (1 + r) ^ t
In this formula:
- P is the principal or starting amount
- r is the interest rate (written as a decimal)
- t is the time in years
So if we are going to invest $1,000 for 20 years at a 10% interest rate, we would just enter the following keystrokes into our calculator:
1000 · (1 + 0.10) ^ 20
This would give us a future value of $6,727. But how did we get there? Let’s dig in a little deeper.
Compound interest year by year
To completely understand how compound interest works, it helps to look at each year of the investment.
Year 1: 10% of $1,000 is $100.
This means you will have $1,100 after 1 year.
Year 2: 10% of $1,100 is $110.
$1,100 + $110 = $1,210 after 2 years.
***Notice that the amount of interest increased by $10. This is interest earned from the interest in year 1.
Year 3: 10% of $1,210 is $121.
You will have $1,331 after 3 years.
***Notice that the amount of interest increased by $11 instead of $10.
Year 4: 10% of $1,331 is $133.10
You will have $1,464.10 after 4 years.
To save us from having to analyze each year, let’s skip directly to year 20:
Year 20: 10% of $6,115.91 is $611.59
This give us an ending balance of $6,727.50
Since you get interest that is based on the original principal amount as well as the interest earned each year, your investment grows significantly faster than the year 1 amount of $100 each year.
This is why compound interest is so powerful!
Who wants to be a millionaire?
Okay, now that we know how compound interest works, let’s do a few examples to show what it would take to become a millionaire. Keep in mind that each of these examples are not adjusted for inflation.
Investing $50,000
You could invest $50,000 at an 11% rate of return and become a millionaire in only 29 years.
But maybe this is too aggressive of a rate of return.
- An 8% rate of return would allow you to turn $50,000 into $1,000,000 in 39 years.
- A 5% rate of return would take 62 years!
As you can see, rate of return really matters. This is why many people try to invest in the stock market, which has a high historical rate of return. They also try to keep their investment fees low by investing in index funds.
Investing money each year
Most people don’t have $50,000 to invest at the start of their working careers. Instead, once someone starts working, they usually try to invest money each month to save for their eventual retirement.
Since the 401(k) contribution limits are $19,500 for 2020, let’s see how many years it would take to become a millionaire if someone maxed out their 401(k). To contribute the maximum, you would need to invest $1,625 per month. Assuming a rate of return of 8% allows you to become a millionaire in only 21 years.
Maxing out your 401(k) means that you will be a millionaire in just 21 years!
Imagine if you and your spouse both did this. After 21 years, you would have around $2,000,000. You could retire at age 42 or 43 as a multimillionaire!
- Contributing $1,000 per month would take 27 years to become a millionaire.
- A contribution of $500 per month would take 35 years.
Action plan
As you can see, compound interest can be extremely powerful on your path to extreme levels of wealth. It can also work against you if you are in debt. So we must do everything that we can to get out and stay out of debt . . . and start investing so that compound interest works for us instead of against us.
For the ultimate guide to getting out of debt, just follow the blue link. Or if you want to calculate how much your investments will be worth in the future, check out this investment calculator.
What are you doing to ensure that compound interest is working for you? Let us know in the comments.
And thanks for reading!
~Nathan
Let’s keep living a great life . . . with the help of money. So what’s next?
- You can travel for free by using rewards credit cards.
- You can get motivated and get out of debt.
- You can check out the previous post and continue to learn.
But no matter what you decide to do, let’s leave the ordinary behind and take action today!
One Comment
Adrian - Investor Tuition
The compound interest formula has one very big flaw to ever be relied on. The interest rate varies over the calculation period. So unless you are investing into a guaranteed term fixed interest investment it becomes totally misleading when used for any growth assets
as their returns fluctuate greatly. As such as a retirement calculator or future portfolio value calculator its a waste if time and should be used with caution.