Count on Compound Interest
By: Source: AARP.org Date Posted: 2005-03-20 12:08:25
Many years ago, someone asked Albert Einstein what he thought was the human race's greatest invention. His reply?
"Compound interest."
Compound interest is a powerful tool for building wealth and financial security. Over time, it can make your money grow dramatically.
Types of Interest
When you deposit money in a savings account, you give your bank the right to use your money — which is called your "principal" — for a certain period of time. In return, the bank pays you a fee, which is called "interest."
There are two types of interest: simple interest and compound interest. Simple interest lets you earn money only on your principal. Compound interest lets you earn money on your principal and your interest. Here's how it works:
A 5-percent simple interest would be equal to 5 percent of your principal only. For example, if you receive 5-percent simple interest on a principal of $100, your investment would grow like this:
- Year 1: $105
- Year 2: $110
- Year 3: $115
- Year 4: $120
- Year 5: $125
A 5-percent compound interest would be equal to 5 percent of your principal and 5 percent of the interest you've already earned on your account. When your interest is compounded, the bank takes the interest that your account has earned during the previous day, week, month, or year. It adds that interest to your principal and then calculates your new interest payment. This means that your account grows faster than an account with simple interest. If you receive 5-percent compounded interest on a principal of $100, your investment would grow like this:
- Year 1: $105.00
- Year 2: $110.25
- Year 3: $115.76
- Year 4: $121.55
- Year 5: $127.63
Compounded interest can be added to your account on a daily, weekly, quarterly, semi-annual, annual, or continual basis. The more often a bank compounds your interest, the faster your investment will grow.
Doubling Your Money -- The Rule of 72
How long will it take for your investment to double with compound interest? To find out, use the Rule of 72. Divide 72 by the interest rate you expect to receive on an investment. For example, if your investment earns 6 percent interest, your money will double in 12 years (72 divided by 6 equals 12).
| At an interest rate of: | Your investment will double in: |
| 3% | 24.0 years |
| 5 % | 14.4 years |
| 7% | 10.3 years |
| 10% | 7.2 years |
| 12% | 6.0 years |
Time Is Money
If you save on a regular basis, your dollars work even harder for you if your interest is compounded. The chart below will help you determine how much one dollar, invested today, will be worth when you retire.
| Value Over Time of $1 Per Year Accumulated at Various Interest Rates | |||||||
| Interest Rate* | Years | ||||||
| 5 | 10 | 15 | 20 | 25 | 30 | 35 | |
| 4% | 5.42 | 12.01 | 20.02 | 29.78 | 41.65 | 56.08 | 95.03 |
| 6% | 5.64 | 13.18 | 23.28 | 36.79 | 54.86 | 79.06 | 154.08 |
| 8% | 5.87 | 14.49 | 27.15 | 45.76 | 71.11 | 113.28 | 259.10 |
| 10% | 6.11 | 15.94 | 31.77 | 57.27 | 98.35 | 164.49 | 442.60 |
| 12% | 6.35 | 17.55 | 37.28 | 72.05 | 133.33 | 241.33 | 767.10 |
| *Interest compounded annually | |||||||
For More Information
A quick Internet search will turn up various types of financial calculators. But you'll find that all calculators aren't created equal. A basic compound interest calculator will prompt you to enter the:
- Amount of your initial investment.
- Rate of interest you expect to earn on your investment.
- Frequency of compounding (monthly, weekly, etc.).
- Number of years ("term") that your investment will grow.
You may get different results with different calculators. Some calculators leave out frequency of compounding altogether and others ask for the final total figure for which you're aiming. To learn more, visit these sites:
Jim Martindale´s Calculators Online Center, The Reference Desk
- This site is the granddaddy of all Web calculator lists and hyperlinks. It gives you direct access to more than 8,570 calculators. The center is heavy on science and engineering and light on finances and investing, but it gets you there.
- URL: www.martindalecenter.com
FinAid
- FinAid is a financial aid site for potential college students. Available through Lycos, this calculator is short and sweet and gives you a figure in a flash. Unlike some other calculators, it lets you enter the frequency of compounding into your equation.
- URL: http://www.finaid.org/calculators/compoundinterest.phtml
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