Compounding: Are You Earning Interest on Interest?
Compound interest is the one of the most powerful concepts in investing. Sometimes it is referred to as earning “interest on interest” because your investment grows based on your entire account balance, not just the principal amount of money you invested in the beginning. This is different than simple interest.
Simple interest can be best illustrated in the context of buying a bond. When you buy a 10 year bond with a 4% coupon for $10,000, you will receive $400 per year for 10 years, plus you receive your principal back of $10,000 after the bond matures. You will have a total of $14,000 after 10 years.
Comparatively, with compound interest, investing $10,000 and earning an annual 4% rate of return would provide $14,802.44 after 10 years. The compound interest return is higher than the simple interest return because the annual interest earned is calculated based on your initial principal plus previously earned interest. With simple interest, your annual interest rate is only applied to your initial principal investment each year.
The power of compounding is magnified by time. The more time that your investment has to compound, the greater effect it will have on your account balance in the future. In the illustration below, you can see the annual investment ($5,000) and rate of return (7%) are the exact same for both investors but one investor starts earlier.
John and Katie both invest $5,000 each year until age 65 and earn a 7% annual rate of return on their respective mutual fund portfolios. The difference is Katie starts investing at age 25 and John doesn’t start until age 35. Due to compound interest and starting earlier, Katie’s account balance at age 65 is almost double what John’s is…a difference of over $500,000.
Starting early and choosing the right investment vehicles are important factors in your money management success. The good news is it is never too late to start and your CommunityAmerica Financial Advisor can help you put a customized plan together for your needs. Please contact us for a complimentary, no obligation consultation today.
Rance Carlson is a CERTIFIED FINANCIAL PLANNER™ with CommunityAmerica Financial Solutions and works primarily out of the Green Hills Financial Planning Center. To get in touch with Rance or an advisor near you, click the button below.