Save early, save often. That’s the golden rule for saving money over a long period – especially when saving for retirement. But, why do so many people emphasize early timing when trying to save? There are a variety of reasons, but one of the key principles that contributes to this strategy is compound interest.
Before we can really understand how to take advantage of compound interest, we have to know exactly what this term means and how it works. To use a metaphor, imagine a snowball rolling down a mountainside. As it rolls further, it accumulates more and more snow until gradually amassing into a gigantic spherical snow-boulder. Likewise, compound interest works by accruing interest on the initial principal and also on the accumulated interest of previous periods.
Breaking Down the Formula
To calculate compound interest, begin by multiplying the principal by one plus the annual interest rate raised to the number of compounding periods minus one. From there, the total initial amount of the loan will be subtracted from the remaining value. Of course, as with most mathematical formulas, it’s easier to visualize:
Compound Interest = P [(1 + i)n – 1]
Let’s take an example of a five-year loan of $100,000 at an interest rate of 5% that compounds annually. What would the interest be in this case? Time to apply the formula:
$100,000 [(1 + 0.05)5 – 1] = $100,000 [1.27628 – 1] = $27,628.16
As you can see, a compounding interest rate could earn you more than a quarter of the original principal in just five years. Taking into consideration the effects of compounding when saving money over years or decades, it becomes clear why compounding interest is exceptionally valuable when planning for retirement. If you’d like to figure out how much money you could earn from compounding interest without having to go through these types of calculations on your own, you can find several simple and convenient online compound interest calculators available for free. You could also speak to your financial advisor.
Understanding the Time Value of Money
So, let’s say you have a hefty chunk of cash. What’s the rush to invest it and gain compounding interest? Why should you hurry? Well, this is best explained with the concept of the time value of money (TVM). This is the concept that existing money available in the present is worth more than an equivalent amount in the future due to potential earning capacity (as well as inflation). As a core principle of finance, any amount of money is worth more the sooner it is received (so long as it is capable of being invested or earning interest). This is also referred to inversely as the present discounted value. When it is possible to take advantage of compound interest, investing early with the TVM in mind becomes essential.
Combating Compounding Debt
Just as there are moments when compounding interest will benefit you, there are also moments when compounding interest could be detrimental. For example, if you have loans that carry high interest rates – such as credit card debt – you could be digging yourself into a hole thanks to compounding interest working against you. Whenever you seek out a new loan or take on new debt of any kind, be sure to double-check whether or not the loan has compounding interest.
Thanks to the Truth in Lending Act (TILA), lenders must disclose loan terms to potential borrowers, including the total dollar amount of interest that will need to be repaid over the life of the loan based on whether it accrues simply or is compounded. By looking at your repayment schedule, you could tell which is which by finding out how much interest must be paid each year – if it stays the same it’s simple and if it grows it’s compounded.
Another useful tip is to look at the loan’s annual percentage rate (APR). In simple terms, the APR converts the finance charges of the loan (including all interest and fees) to a simple interest rate. A major difference between the loan’s interest rate and its APR could indicate one (or both) of the following two things: either your loan has compound interest or it includes heavy fees on top of the regular interest rate.
The Bottom Line
For those looking to retire sooner rather than later, getting a handle on compounding interest could make a massive difference. While this concept is fundamentally neutral, it has the capacity to do great good – or great harm – to your individual finances. Remember, finance is rarely straightforward. When making any kind of financial decision, act carefully and consider all of your options. Before you commit to a particular choice, it generally helps to speak with a financial advisor first.