These Simple Compound Interest Charts Will Blow Your Mind
For most people, the idea of becoming a millionaire seems like an impossible task.
Yet it’s not impossible to become a millionaire and you don’t need to be a professional athlete or famous musician to get to that level, either.
All you need is consistent income, time, discipline, and the right strategy. With a smart approach, compound interest can take care of the rest.
Buckle up. These simple compound interest charts are going to blow your mind and show you exactly how a small amount of money can snowball into a massive chunk before you know it.
The compound interest charts that will change everything
The Motley Fool offers two incredible charts that demonstrate the unbridled power of compound interest.
Chart I: Making a Single $1,200 Investment
In the first chart, The Motley Fool explains how making a single $1,200 investment can grow over time with compound interest.
As the chart shows, putting the money into a savings account with a 0.1% annual interest rate, a money market account (1%), or certificate of deposit (2%) and leaving it there for 40 years won’t do much.
Total payouts over a 40-year period amount to $1,249, $1,787, and $2,650, respectively. For the most part, those annual returns are paltry.
Put that same amount into the stock market with a 9% average rate of return, however, and that investment can turn into almost $40,000 over 40 years.
Of course, most investors don’t just make a single contribution and leave it for 40 years. Let’s take a closer look at what happens if you make a $1,200 contribution every year.
Chart II: Making a yearly $1,200 investment
The second chart shows what happens when you invest $1,200 every year for 40 years. Take a look at the chart and you’ll see the results are shocking.
In just 10 years, your $1,200 investment turns into $13,278—and that’s just with a savings account at 0.1% interest. The same 10-year outlook in the stock market yields $22,173.
Over the course of a 40-year period, an annual $1,200 investment in the stock market returns a jaw-dropping $479,642.
Here’s the cool part: With an individual retirement account (IRA), you could put a whopping $6,000 away into retirement annually, loading up on mutual funds, stocks, and other financial instruments. And with a 401(K), you could put $19,500 into a tax-advantaged retirement account every year and do the same.
By maximizing each retirement vehicle, you can potentially retire a very rich individual.
The power of compound interest
As you can see, compound interest is pretty powerful. It’s so powerful Albert Einstein supposedly once called it the eighth wonder of the world.
Let’s take a closer look at what makes compound interest so special.
How compound interest works
In layman’s terms, compound interest is when interest collects interest. In other words, your initial investment sits in an account for a set period of time and builds interest. At that point, you collect interest on the principal amount in addition to the interest you’ve earned on it.
Compound interest can be calculated based on different interest schedules. Interest can compound daily, weekly, monthly, or annually.
It’s important to understand the total number of compounding periods before making an investment. That way, you can get a better sense of how to calculate your total return.
Simple interest vs. compound interest
The opposite of compound interest is simple interest, which only factors in the principal amount over time.
When you put money into an account that calculates simple interest, you won’t generate interest on the interest that your money accumulates.
Tips for maximizing compound interest
Stop delaying and start saving
Time is the most important factor when it comes to collecting compound interest. If you’re interested in maximizing compound interest, stop delaying and start putting more money aside now so that it can grow.
Lose the mindset that you can start saving tomorrow and everything will even out in the end. Every day you avoid investing will dramatically reduce your overall compound interest over a period of 30 to 40 years.
Max out your retirement plans
One of the downsides to investing in a brokerage account is that any gain is treated as taxable income. So, as you make money off compound interest in a brokerage account, you lose it by paying taxes on dividends and capital gains.
The best way to avoid losing money on annual taxes with a brokerage account is to put your money in a tax-friendly individual retirement account (IRA) or 401(k). That way, your money can grow on a tax-free or tax-deferred basis for decades and compound, potentially saving you thousands in taxes.
Don’t touch your savings
As your money starts to pile up due to compound interest, you’re going to be tempted to access it to cover daily expenses or buy things you really want.
Avoid this at all costs. Instead of touching your money, keep it safe in an account where it can keep growing.
In the end, you’ll have much more money if you don’t tap into your funds and let them keep accumulating compound interest instead.
Frequently Asked Questions
How much should I have in retirement savings?
The trick is to save your annual salary by the time you’re 30. So if you earn $40,000 per year at age 30, you should have at least $40,000 in the bank. If you make $60,000 at 30, you should have at least $60,000 tucked away.
By the time you reach retirement age, you should have several times your annual income put into retirement savings. That way, you can live comfortably without having to worry about money.
One tip to keep in mind is to stop thinking about retirement in terms of reaching a certain age. Instead, you should think about retirement more as reaching a certain financial threshold.
Don’t say you want to retire at 65. Say you want to retire with $1 million or more in the bank.
What is financial freedom?
Financial freedom simply refers to the moment when you have enough money that you can stop working because you have to and only work because you want to.
In the past, retirement used to be seen as a way out of the workforce. That is increasingly a dated concept.
The truth is that humans need work. We all need a purpose and a motivating factor to keep us reaching for new heights.
The goal of life is to learn, grow, and strive to reach new shores, not to work endlessly for a paycheck doing something you don’t love.
Financial freedom is the moment when you change course and embark on your own journey, one that you control.
Can compound interest help you reach your financial goals?
Earning compound interest is one of the best ways to reach your financial goals. However, there is one drawback associated: you need time to make it work. To maximize compound interest, you need to be prepared to wait for three or even four decades.
In the meantime, you’ll also need to save and invest separately to generate cash for things like buying a house, starting a family, and launching a business.
For the best results, create a diverse financial strategy that will allow you to achieve growth without waiting your entire life for compound interest to set in.
How can I build wealth?
Building wealth isn’t as hard as it may look. It boils down to minimizing debt, making sound investments, and putting your money into strategic accounts where it can grow and collect interest over time.
One of the easiest ways to build wealth is with a side hustle. You can drive for Uber or Lyft, walk dogs, or babysit, among other options. Simply put, the harder you work, the more money you’ll bring in.
As you start to make more money, protect it by putting your funds into tax-friendly retirement accounts. Over time, your net worth will increase and you’ll slowly build wealth.
Another great way to build wealth is to invest in real estate. This doesn’t mean you have to buy properties outright. Instead, you can buy shares of real estate investment trusts (REITs), which are required to pay out dividends and could contribute to a steady cash flow.
- Are REITs a Good Investment?
- Best Side Hustles for 2021
- 6 Tips for Growing Serious Wealth in Your 20s
- REIT vs. Real Estate
Is compounding interest necessary for retirement?
If you want to retire someday with a lot of money in your bank account, you’ll need to maximize compound interest. To do that, start putting extra money away into retirement accounts now so that it can grow over time.
The longer you wait to get started, the lower your overall return will be in the end.
What is a nest egg?
A nest egg is a term used to describe an accumulated amount of wealth. If you work for 10 years and save $100,000, that’s your nest egg.
The trick is to turn a small nest egg of $100,000 into at least $1 million or more. And you can do this by collecting compound interest.
The Bottom Line
Maximizing compound interest is one of the most important personal finance strategies you can implement. If you want to reach financial freedom someday, you’re going to have to start maximizing compound interest. It’s that simple.
If you haven’t already done so, consider opening a brokerage account and retirement account, and revisit your budget to prioritize investing. Make it a point to start putting as much money as you can into these accounts. And if you need to, start with a robo-advisor for automated investing.
Above all else, remember that investing isn’t about being perfect. It’s about getting started as soon as you can and making moves in the market.
Your money won’t invest itself. If you want to make your money compound and grow, you have to dive in.
Consider this a push into the deep end. It’s time to start swimming.