compound-interest

The Amazing Power of Compound Interest

Probably my favorite strange but true fact of all time involves a sheet of paper and the Moon.

Simply put, how many times would you have to fold a (giant) sheet of paper to reach the Moon? Your first thought might be that it would take millions of folds to get anywhere near it. However, the real answer is that you would only need to fold it 42 times to reach the Moon.

Of course, you would never be able to carry out this little test in real life but it shows us how exponential growth can quickly turn something relatively small into something a lot bigger. The height of the piece of paper doubles with every fold, meaning that it begins to rapidly eat up the distance after a certain point.

When it comes to your money, compound interest can’t send you to the moon but it can give you exponential growth of the capital you invest. If you use an interest bearing bank account then you will see how interest gets added to it on a regular basis. However, if you regularly add cash or take it out then it might not be entirely obvious exactly how much interest you are earning.

See How $100 Grows

So let’s take the example of $100 in a bank account that pays 3% interest each year. It’s clear that after the first year you will have gained $3 in interest (we’ll keep life simple by ignoring any tax issues for the moment and assuming that the interest is being compounded annually). However, for the second year, you gain interest on the $3 interest as well as on the $100 capital. This will give you $3.09 in interest for the second year, so $6.09 in total interest for the two years.

As time goes on the amount of interest you get each year keeps on rising, as the interest to date also attracts interest. So, after 10 years your total interest figure adds up to over $34, rather than the $30 dollars you would have earned had you withdrawn the interest as you went along.

After 20 years the total amount of interest gained is over $80, giving a total in your account of more than $180. Again, if you had consistently withdrawn the interest and spent it each year then not only would you still only have your original investment of $100 sitting in your account, but you also would only have been paid $60 in interest over the 20 year term rather than the $80 which compounding interest has generated.

We need to bear in mind that this is an example using a small amount of money and a relatively modest interest rate. The results would be a lot more impressive with, say, $100,000 in the account to start with. In this case, you would have received a very healthy $80,000 in interest over those 20 years.

Another point to remember is that for those who prefer to invest in the stock market rather than place their cash in a high interest savings account, the theory of compound interest also applies to share dividend payments as well as to interest on savings accounts. For this example let’s say that you own 100 shares at a market value of $10 each. If your yearly dividend is $0.20 per share then you have a choice of collecting your $20 or else buying 2 new shares with the money.

In the case of taking new shares the next batch of dividends will see you receive the money on your new total of 102 shares, giving you $20.40 if the dividend hasn’t changed since last year. If you again take the option of accepting new shares with the dividend then your total number of shares will keep on rising without you spending any more money on them. The $20.40 dividend will mean that you now have 104 shares.

Of course, if you are looking at a long term savings account investment then the interest rate you get will make a big difference to how much interest you receive. If we go back to that original example of $100 but change the rate from 3% to 5% we can see that the interest gained over the 20 years rises from $80 to more than $160.

Have you experienced the pleasure of receiving compound interest in the past or do you plan to do so soon?

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11 Responses to The Amazing Power of Compound Interest

  1. Interesting about the piece of paper and how many times you’d have to fold it to reach the moon. Compound interest is amazing!

  2. Lance @ HWI says:

    Compound interest is one of my favorite things in life. I think a lot of people forget about dividends. No big secret, the earlier you start the earlier you can get your money to work for you!
    Lance @ HWI recently posted…Doing All The Wrong Things Trying To Get RichMy Profile

  3. Since my parents first opened an account for me at the community Savings & Loan–I must have been ~7 years old–I’ve been fascinated by interest. Someone will give me money for doing essentially nothing?? How cool is that!
    Kurt @ Money Counselor recently posted…Americans’ Credit Card DebtMy Profile

  4. I was introduced to compound interest as a kid when my Mom would take us to the bank to deposit some of our weekly allowance. At the time I was earning a cool $0.01 per month, but being young, I thought I was on my way to riches from these extra pennies I was earning. That feeling has stuck with me since and I am a big fan of compound interest.
    Jon @ Money Smart Guides recently posted…E*Trade Review: Investing Made EasyMy Profile

  5. Myles Money says:

    Understanding compound interest is so important, every bit as much for understanding how debts get out of hand as how your savings increase over time. Financial Literacy classes were introduced recently in the UK but sadly it appears they haven’t been thought through very carefully because things like compound interest won’t be on the syllabus.
    Myles Money recently posted…Banana Milkshake #FrugalFriday #VideoMy Profile

  6. Understanding compound interest is a great thing. I think its one of the safest ways to earn after a long period of time with no need to gamble.
    Amos @ Modest Money recently posted…Credit One Bank® Visa® Platinum ReviewMy Profile

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