Before I go into explaining compounding interest, I want you to think about this:
If someone were to approach you today and give you a choice, what would you choose: receive a penny today that will double every day for a month, or $1 million today?
A lot of people get caught up in the initial amounts of $1,000,000 or $0.01. With investments, there are two types of interest, simple interest, and compound interest. We will focus on compound interest since simple interest is rarely ever applied today. Compound interest means that you will earn interest on your interest and is the reason why so many investors are successful and build long-term wealth.
Compounding on Investments
Let’s assume you invest $100,000 at a 5% interest rate compounded annually. After your first year, $5,000 is added to your account. During your second year of the investment, your 5% interest is calculated on your new investment balance of $105,000. As a result, you would receive a $5,250 interest payment that is added to your investment for a new balance of $110,250. After 30 years, this initial $100,000 investment would turn into $432,194, resulting in a 332% gain on your investment.
| Initial Investment | Value In 1-Year | Value In 5-Years | Value In 10-Years | Value In 30-Years |
|---|---|---|---|---|
| $100,000 | $105,000 | $127,628 | $162,889 | $432,194 |
As you can see from this, the power of compounding interest is very powerful. If you picked the single penny and double it every day, at the end of the 30 days, the penny grows to $5,368,709.12. It is important to note that time can greatly affect the value. If you take the same options, but change the doubling to only 27 days, you will only end up with $671,088.64.
This same growth applies to investments too. Starting at different ages with vastly reduce your compounding growth. Let’s assume at 20 years old, you start saving $100 a month and grows at 5% each year. Assuming you retire at age 67, this would grow to roughly $224,430. Assuming you start at 30, this drops substantially to roughly $128,051 and roughly $68,883 if you started at 40.
The key take away from this is that you want to start investing and saving as early and often as possible. While the 5% returns may get you a modest return today, earning 5% throughout your life will set you up for huge returns later in life and as you approach retirement.