fff University: Compounding Interest
24. May, 2008 
9 Comments
The reason that time is such a powerful player in the world of personal finance is because of compounding interest. Compounding interest is the money you earn, by letting someone else borrow your money. Why else would you put a bunch of money in the bank, unless they paid you for doing so?
For example, say you invest $5,000 in a mutual fund. Mutual funds have typically provided 10-12% return in interest. We’ll use 12% interest for this example. Let’s look at this money over the course of a few years:
- $5,000 @ 12% = $5,600 : Net Change = $600
- $5,600 @ 12% = $6,272 : Net Change = $672
- $6,272 @ 12% = $7,025 : Net Change = $753
- $7,025 @ 12% = $7,868 : Net Change = $843
- $7,868 @ 12% = $8,812 : Net Change = $944
- $8,812 @ 12% = $9,869 : Net Change = $1,057
- $9,869 @ 12% = $11,053 : Net Change = $1,184
- $11,053 @ 12% = $12, 379 : Net Change = $1,326
- $12,379 @ 12% = $13,864 : Net Change = $1,485
- $13,864 @ 12% = $15,528 : Net Change = $1,664…
As you can see in this example, in only 6ish years, you have doubled your investment. In 10ish years, you have tripled your investment. To continue this example (without all the typing), at year 20 the investment would be worth over $54,000. After 40 years, you would be carrying around $593,000! And it all began with $5,000 and a little bit of interest.
Another note worthy point for all the nerds out there – because you are dealing with percentages (i.e. 12% interest), the Net Change in the value of your investment grows at an exponential rate for as long as the money is invested. Thus, the get’n keeps getting good’r.
Just imagine, paying $11,000 dollars for a $20,000 car. Now that is a heck of a deal. All you need is 5 years of planning. Or setting $5k aside when your child is born and having college paid for. These are just a few great examples of the power of compounding interest and saving with a plan.
nice example but the optimistic returns paint a pretty rosy picture. Select the 10% of the mutual fund range and account for 3% inflation and you have a 7% real return. At that level it will take 11+ years instead of 6+ to double your money. Which is a little less magical. Compounding interest is great but rate of return is key.
scott, you raise a good point. to take compounding interest to a deeper level, you would/should incorporate the time-value of money aspect to it. however, for this generic example, i did not. my point was to depict a simple example of the power of compounding interest based on a few assumptions (like the interest rate of 12% – which although optimistic, obtainable).