By Jamie Wagner, Ph.D.

Understanding Compound Interest

When I talk about investing to young people, I tell them how powerful compound interest is and that it’s even more powerful because of their age. But, I don’t really think they fully understand the concept. In fact, I don’t think most people really understand how compound interest works. So let’s take a look.

What is Interest?

Interest has two definitions. 1) A fee a credit union (or bank) or lender can charge to use their money. For example, if you take out a personal loan from Centris Federal Credit Union, they will charge you interest to use their money until it is paid off. 2) A fee you collect from someone else using your money. For example, if you buy stock in a company, you can earn interest for letting that company use your money. Depending on the situation, compound interest can either work for you (example two) or against you (example one). For this post, let’s look at how it can work for you.

How Does Compound Interest Work?

Interest is the money paid to you based on a percent of the amount of money the company/person/etc. is using. Compound interest is the interest paid on the amount of your money being used plus interest on the interest you’ve been earning thus far. Here’s a simple example. Let’s say you invest $100 at 10% compounded annually the first year you’ll have:

$100 (Initial amount) + 10 (100 x .1=10 interest) = $110 total

In the second year you’ll have:

$110 + 11 (110 x .1=11 interest) = $121 total

Now this doesn’t seem very powerful, and it’s not… yet! Compound interest’s power comes from the fact that as years go by your interest accumulates more and more rapidly and you make more and more money off of the interest.

Compound Interest In a Graph

Compound interest graph

Here’s a graphic using a compound interest calculation from Nerd Wallet. This shows how much money you’d have in 10 years if you invested $100, making no additional payments at a 10% annual rate. The blue is the principal and it remains constant, but as the years go on the power of compound interest is evident as the green bar gets higher and higher.

Investing For Your Future

The previous example was overly simplified, but there are some real examples of how necessary investing is for your future. It’s not a new idea that everyone needs to save for retirement. I also want to add that it’s necessary to start as soon as you can. Why? Compound interest!

Compound interest graphSo let’s do another example. Suppose you invest $100 a month and earn 6% interest each year. In 10 years you will have $16,654. If you had simply hidden the money away under a mattress, you’d have the principal amount of $12,200 but because of compound interest you’d have an extra $4,553.

Now, imagine that you’re 22 starting on this same savings plan and you’ll save $100 each month until you’re 65 (43 years). You’d have over $244,000! But, the most amazing part of all of that money is to see the difference in interest and principal. As you allow your money to sit in an investment and earn compound interest, your money really takes off because of the interest. The green (interest) is much larger than the blue (principal).

Compound interest graph

Interest is an incredible tool that you can use to your benefit. Don’t be afraid of investing, but be wise in your investments. There are many avenues available to you through your membership with Centris Federal Credit Union. Speak to one of their representatives today to start you on the right path.