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10 years your total interest figure adds up to over $34, rather than the $30 dollars you would have earned had you withdrawn the interest as you went along.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 Again, if you had consistently withdrawn the interest and spent it each year then not only would you still only have your original investment of $100 sitting in your account, but you also would only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?