The Magic of Compound Interest, Revealed!

You’ve likely heard about the magic of compound interest, and it really is something to behold when you see it and experience it in action.

My favorite example of how compound interest works is the time it takes for your invested money to double. The answer is simple if you know the Rule of 72.

Divide 72 by the interest rate at which your money will compound, and that’s approximately how long it will take to double your money. At 6%, it takes 12 years. At 9%, your money doubles in 8 years. At 18%, 4 years. Pretty cool, huh?

This Friday Feature was recently featured in a Sunday Best post and was originally published on We Want Guac.
magic of compound interest

 

With so much doom and gloom, it’s time to remind you that magic is real. I’m not the one to tell you about goblins and ghouls and the faeries of olde, but I’m delighted to tell you about a more modern form of magic.

“Compound interest” sounds cold and industrial at the outset when that dreary name masks the glittery core of magic within. It’s simple! Easier to learn than any sleight of hand! Even federally recognized AS MAGIC!

Not even joking with that last point; it ain’t April. Compound interest magic is a real part of our world today that YOU can take full advantage of. To understand it, look at regular ol’ interest. If you’re getting 5% interest on $100 you lend a friend, that means you’ll get your $100 back plus an additional five percent ($105). Which is pretty cool.

Compound interest means you get back that $100, plus that $5, PLUS the interest that $5 has also earned you. Interest earns interest earns interest, which can easily be replaced with “money” or “more gravy” or, I dunno, “f r e s h  g u a c”. That interest keeps multiplying, or compounding, and you’re left with more and more money as long as you keep it all invested.

And that’s it.

Well… that, and the one other caveat of investing it in the right thing.

 

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Enter: Index Funds, Stage Right

 

No matter what hotshot stock or company you invest in, it’s very hard to predict how well your shares in the enterprise will actually perform. Because of this volatility I like to bank on something more general and assured, like the innate drive of human innovation. That’s not me getting all grand and mighty with you; it’s me deciding to go with index funds as my preferred investment choice.

Index funds are for the beginner investors and lazy future millionaires. They’re a baseline for evaluating the returns of any particular investment, being the true “set it and forget it” type of asset. If your entrepreneurial venture or other moneymaking deal can’t beat its return, why bother putting in extra? At this stage in the game, I wouldn’t put my compound interest returns at risk like that.

I’ve even got the cold hard facts to prove me right.

Since its inception in 1926, the S&P 500 – most used to represent the entire stock market – has been 10-11%. If you look at all of its returns since 1970, the average is 10.9%. Since 1990? 10.7%.

 

fool.com s&p returns compound interest

 

Now I don’t know about you, but those are encouraging investment numbers. Why should I have to go through the drudgery of picking individual stocks that might do well? I mean, with an index fund I’ve got as close to a guarantee of double-digit returns as you’re gonna get in business.

My Vanguard account is the perfect example. In it I hold only their VTSAX index fund (along with exactly 8 shares of GameStop for the lulz). Since 2017 I have invested roughly $60,000 in that index fund. Thanks to VTSAX, I have “earned” almost $40,000 in returns on that.

That forty grand was not a typo.

That’s an amount from investing for only FOUR YEARS, people!

 

financial independence returns compound interest magic
No I am NOT kidding, this is my exact performance graph as of July 6th.

 

This is during a big bull market when it clearly didn’t take much stock-picking to make some moolah. But also during a bear market in March 2020. At that time I saw my net worth fall by roughly a third; for every three dollars I had in February, I had two in March.

In response to this sudden and dramatic change, I set into motion a particular plan. A plan I’ve honed for almost half a decade at that point. A plan that would see me through to the other side of this crisis with almost double the original amount.

I can now sum up this stroke of brilliance and ingenuity into three simple, bounteous words to reveal how I came out totally unscathed:

 

I did nothing.

 

Yep, didn’t change the way I did things whatsoever. It took until June to reach my former high. Then it skyrocketed to the $245,000 I have today (so close to QuarterFI!)

Compound interest, that lovely federally-designated magic it is, is how I’m now closing in on a quarter million dollars. And you, too, should get in on this abracadabra party! Promise, it doesn’t take much to get admitted!

 

How You Can Enjoy the Compound Interest Magic

 

Let’s say you have a thousand dollars. Getting that to grow by ten percent in one year means you now have eleven hundred dollars. Now, that hundo is making it grow even more. Another year and you’ve now got $1,210.

At the end of Year 5, you’ll have $1,610. At the end of Year 10 that’s almost $2,600. That’s all WITHOUT you adding more money to the amount – just leave it in that index fund and let it ride, baby.

 

Year Amount
0 $1,000
1 $1,100
2 $1,210
3 $1,331
4 $1,464
5 $1,611
6 $1,772
7 $1,949
8 $2,144
9 $2,358
10 $2,594

 

I deliberately used a “small” number here to best illustrate how much more you can get. The bigger the numbers get, the better.

Have ten thousand dollars invested? Watch that grow to over $26,000.

 

Year Amount
0 $10,000
1 $11,250
2 $12,375
3 $13,613
4 $14,974
5 $16,471
6 $18,118
7 $19,930
8 $21,923
9 $24,115
10 $26,527

 

 

Fifty thousand? You’re looking at a solid $129,650.

 

Year Amount
0 $50,000
1 $55,000
2 $60,500
3 $66,550
4 $73,205
5 $80,526
6 $88,578
7 $97,436
8 $107,179
9 $117,897
10 $129,687

 

Have a hundred thousand dollars invested? Way to go, that’ll be $259,300.

 

Year Amount
0 $100,000
1 $110,000
2 $121,000
3 $133,100
4 $146,410
5 $161,051
6 $177,156
7 $194,872
8 $214,359
9 $235,795
10 $259,374

 

It’s especially awesome to use this 100k example because that’s right about the time you’ll see crazy gains. Why? Because 1% is one thousand dollars. Because getting an average (10%) return is watching your investments go up by five digits without adding another penny in.

And so on, and so forth.

This is hard to do if you have a below-average salary. But remember, you’re still young and you’re going up against the cogs of capitalism. As long as you can reach an average salary of $50,000 – while managing your spending – you can put five figures towards your investments each year. Even more if you have access to tax-advantaged accounts like a 401(k), because then you don’t have that tax taken out.

 

[PoF: Compound Interests are tons of fun to play with. I even built one of my own that can factor in different compounding timeframes or drag from taxes and fees.]

 

 

You can download this calculator and a bunch of others. Enter your name and email, and I’ll send you a copy.

 

 

 

Compound Interest Pays The Most RIGHT NOW

 

Thanks to the magic of compound interest, I could stop saving completely and STILL become a millionaire. The only reason I can do this so quickly is because I got started investing while I was still super young. Time is the most important asset to have to earn the most compound interest; as a youngin, that’s what you have in spades, no-guarantees and YOLO aside.

You’ve practically got me on my knees if you haven’t yet hit your 30th birthday. PLEASE, y’all, PLEEEEEEEEEEASE start investing RIGHT NOW! It’s not going to affect me at all, this begging is solely to give your future self a much more phenomenal life. Please please pleaseeeeee start investing today! This week! As soon as humanly possible!

Think of the corporations!!

Besides tax dodging and underpaying their employees, this is one of the core ways the rich continue to get richer. And they teach their kids to get this done as early as possible, too, so they can similarly get in on the action and perpetuate generational wealth. You don’t earn as much if you wait until you’re 30 to get this sorted.

Since you’re young, it’s YOUR money that’s going to have the most time to compound that interest and work that sexy magic. The mega rich want to squeeze as much money out of their companies as they can and YOU can benefit!!

Not only that, they’re more jealous of you than you can possibly imagine. Why wait for the revolution to go eat the rich? Do so metaphorically and get in on the action ASAP!!!

In all seriousness, this investing stuff is best used at the earliest possible time. Today’s dollars are the most valuable in terms of growth in the long run. In my case I only had to save for five years to have a smooth ride to retirement.

Imagine not needing to worry about saving a penny towards your future because you’ve got a nest egg already generating what you’ll need. I don’t know anybody who wouldn’t pass up the chance to use those savings for other endeavors. The goals and dreams you could pursue with that extra cash are utterly extraordinary.

 

Getting Started

 

You don’t need that much at all to get started. Gio, my 18-year-old hotshot brother, got his set up with roughly a thousand dollars. He’s been adding different amounts since then and is now sitting pretty at $3,000.

Most of that is from his contributions, but that three grand includes hundreds of dollars in gains. Those gains will now similarly earn more money thanks to magic compound interest. All you need to do is open an account, invest in an index fund, and bippity boppity boop bitch you’re done.

If you’re deciding on where to open an account, I’d recommend a large brokerage like Vanguard or Fidelity for their low-cost index fund options. Follow the prompts to set up an account, transfer your money in, and buy the index funds you want. And keep going from there.

That is how you can make an income stream for yourself that requires next to zero work. It’s how you get in on that magic compound interest. Most importantly, it’s how you set up the most awesome array of options for yourself further down the line. This can mean financial independence a la FIRE. Or, really, anything you damn well please. It’s your life, after all. Set yourself up for a nice one with doing exactly this.

I’m not here as your fairy godmother or Hogwarts professor so I can’t offer you garbled words to transform your life. What I can do instead is offer you some assistance to transform your life instead. No wands needed.

 

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What do you think? Have you seen the magic of compound interest with your investments? At what age did you start investing?

7 thoughts on “The Magic of Compound Interest, Revealed!”

  1. Another way I like to illustrate this is to map out what happens when you double your money, over time. Let’s say you’re 20 years old, you have 10k in a Roth IRA that earns 10% annually on average, and you never add another cent. It should double about every 7 years. At 27, you’d have about 20k. Around age 34, $40k. At 41, $80k. 48 … $160k. 55 … $320k. 62 … $640k. In the years between age 62 and 69, your money should grow from $640k to $1,280,000. In those last 7 years, you’re going to make $640,000 … all from that original $10k investment. For me, that’s where things get exciting, when big numbers double. Now imagine that instead of never adding another cent to that Roth, you tossed in 7k a year between ages 20-27 and then stopped contributing. At 27, you’d have (very roughly) $69k. At age 48, you would hit about $552k, and your Roth would be at $1,104,000 around age 55. Keep going and retire at age 62, and you should have about $2,208,000. Without adding any money to your Roth after age 27.

    Reply
    • Stellar way of demonstrating this, Dean! It’s numbers like this that get new folks excited about investing in the first place, which we need more of as more grow financially literate. Going along with your examples, if someone in their 20s wanted to reach $1 million at 65 years old all they’d have to do is work backwards to figure out how much they should aim to have at certain ages. $500k at 58, $250k at 51, $125k at 44 and so on, all the way down to needing $31,250 by the time they’re 30 years old. I think with numbers like this it’s both thrilling to see the results and reassuring to know it’s easier than they likely thought.

      Reply
  2. Subscribe to get more great content like this, an awesome spreadsheet, and more!
  3. Not to go against your point because I totally agree but I just wanted to play devils advocate and point out that stocks can be more volatile than the bull market we’ve seen and your compound annualized return can be a lot less than what you think. You should do an article on average returns vs CAGR. For example a 100% increase one year followed by a 50% decrease the following year lands you at 0% ….. not 25% (as what you’d calculate by averaging). Last year was never before seen. Definitely hold steady and keep investing but don’t extrapolate the crazy gains to continue forever. They’ll mess up your calculations. Really great online calculator that shows CAGR and adjusted inflation of stock market. http://www.moneychimp.com/features/market_cagr.htm

    Reply
    • You’re absolutely right, but keep in mind that past stock market returns reported in the post are the actual CAGR (a.k.a. geometric average) as opposed to a simple average of different years’ returns, and invested money will see those actual returns and compound accordingly.

      Cheers!
      -PoF

      Reply
  4. The biggest magic is when an investor starts young, as shown by the example above. And a Roth account is a great choice for the young, and a nice diversification choice in addition to pretax accounts for older folks like me.

    Unfortunately I didn’t start seriously saving until about age 45, so I had a lot of catching up to do, which required investing far more than the example above to hit my FI target.

    Reply
  5. Compound interest is amazing and it speaks to the power of investing! For a fun take on the rule of 72, take the annual inflation rate and divide it by 72, the resulting number is how often prices double. If that isn’t a good motivator to keep cash to a minimum, I don’t know what is!

    72 / 2% inflation = 36 years

    Reply
  6. I think Warren Buffett mentioned that compound interest is like the 8th wonder of the world or something lol.

    I played around with a DCA calculator, and apparently if I had put $50K/yr in the SP500 every year from 2000-2020, it’d be worth 3 million dollars now. And if I had done the same, but for apple stock instead, it’d be worth $64 million.

    Compound interest is the closest thing to literal magic I feel.

    Reply

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