By Julie Cazzin, with Allan Norman
May 28, 2021
The story goes like this: Benjamin Franklin left $5,000 to each to the cities of Boston and Philadelphia when he died in 1790. The goal was that each city would create a fund that would last for 200 years. The needy could borrow from that fund at five-per-cent interest. After 100 years, each city could withdraw $500,000 from the fund, leaving the rest of the money to work for the next 100 years.
Why did Franklin do it? To help people understand the importance of compound interest. As you’ll soon find out, compound interest can either speed or sabotage your dreams to achieve financial freedom. It’s great if you’re routinely saving money, but it can be a cruel mistress if you’re borrowing it.
Franklin described it best when he proclaimed, “Money makes money. And the money that money makes, makes money.” It’s likely the simplest description of compound interest you’ll ever hear.
Money makes money. And the money that money makes, makes money
BENJAMIN FRANKLIN
In a nutshell, the key to growing your wealth is to use compound interest to your financial benefit. And time — as all long-term investors know — is compound interest’s best friend. Here’s a primer on how it can change your life.
What is it? According to Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” Put simply, compound interest is the ability to earn interest on top of interest, resulting in exponential growth. It’s interesting to note that more than 90 per cent of investing great Warren Buffett’s total net worth was accumulated after he turned 50. This was all due to the interest earned on his previous earnings and, eventually, the interest earned on his interest.
Who invented it? The origin of compound interest can be traced back to the Old Babylonian period (circa 2000 to 1600 BC). We know that the Babylonians called it “interest on interest,” and even solved mathematical problems with it.
How do you calculate it? There is simple interest, and then there is compounding interest. Of the two, simple interest is the easiest to calculate in your head and project forward. This is why many people don’t truly grasp the power of compounding and are willing to take unnecessary risks with their money by searching for higher returns or timing the market, instead of letting the power of compounding work.
The simple interest formula is:
(Investment value) x (the interest rate) x (# of years invested) = ending value
Let’s crunch the numbers and see how someone might project their investment returns using simple interest. If you invest $100,000 at six per cent, it will give you a $6,000 return in a year. If you do that for 12 years, you will make $72,000 in interest and have a total of $172,000.
Now, let’s run the numbers to see how compound interest is calculated. First, the basics. It’s great to know that the compounding interest formula is P(1+r/n)^(nt), but you don’t need to understand the formula to understand it.
Here’s a great example of how it works: $100,000 + 6 per cent = $106,000, then next year $106,000 + 6 per cent = $112,360. After repeating this for 12 years, you will have $201,219 — or double your money. I used this a calcuator to work it out rather than the complicated looking formula above.
How does it grow? Compound interest isn’t intuitive and that’s why so many people have trouble understanding it. Years ago, my nephew asked me this question: “What would you rather have? One penny, doubled every day for 30 days, or $1 million 30 days from now? You may be tempted to do what I did, and say, “$1 million, of course.” You, too, would have left more than $4 million on the table. Here’s an easy chart to show you how that penny grows over 30 years.
What do you see? If you look very closely, you’ll see the growth of that penny is truly amazing. One penny doubling every day for 30 days turns into more than $5 million. It starts slow, but the last few days of compounding (specifically the last three days of the month) were huge growth days, revealing the option of compounding the penny to be the true winner of this match-up.
Five factors are key
- Time and patience are crucial to capturing the benefits of compound interest. Sure, in real life there isn’t an investment that doubles every day, but there are still lessons to be learned. You can do that best by thinking in terms of years instead of days for your own investment plan. The lesson? The longer you leave your money invested to compound, the more you’ll earn.
- Missing one day of growth in our 30-day compounding chart would mean you’d make only $2.6 million rather than $5.3 million (first column in the table). Long-term investors who try to time when to get in and out of the market, or search for higher returns, risk missing that one day. Sure, the timing approach might work, but it is subject to a lot of chance. Odds are it won’t. All this is to say that the less risky way to build wealth is to take an evidence-based approach, accepting market average returns and letting the power of compounding take over.
- Understanding the frequency of compounding. The pace at which interest is compounded — whether it’s daily, monthly or annually — determines how quickly your principal balance will grow. Make sure you understand how often interest compounds when opening a savings account or making an investment.
- Withdrawing money in the early days can be fatal to compounding growth. Withdrawing 16 cents after five days may not seem like much, but it is the same as starting over (column two) and results in having only $300,000 after 30 days, rather than more than $5 million.
- Waiting to start investing also has a huge impact on the amount accumulated. Delaying means the amount needed to invest to make up the difference is also compounding. Notice a five-day wait means starting with 16 cents (column three) to reach $5 million.
Who benefits from compound interest? Investors do. Given enough time, everyone has the ability to save and invest enough money to amass the level of wealth necessary to one day, for the rest of their lives, wake up in the morning and do what they want, when they want and with who they want. The key is simple: start investing and focus on your savings rate and investing often, rather than simply looking at your investment return.
Who loses? Debt and inflation also compound, but not in a positive way because they erode wealth. Controlled debt tied to a home, business or other types of growth assets is not bad, but you want to avoid or eliminate consumer and credit card debts as much as possible. Avoid the cycle of accumulating debt and withdrawing from investments to pay them off.
Inflation, too, is a sneaky killer of wealth that goes unnoticed, particularly to retirees — and others — low interest savings accounts. Just like compounding interest, you don’t notice it until you see the corrosive effect.
It’s easy to see this in an example from everyday life. Let’s say a loaf of bread today costs $2.50. Using the compounding calculator and applying two-per-cent inflation, that same loaf of bread will cost $3.17 in 20 years, and double in price from the original $2.50 to $5.09 in 36 years. Now, you may say that one loaf of bread isn’t a big deal, but everything else is increasing in price along with the loaf of bread. Financial planners refer to this as “protecting your purchasing power,” or the ability to still be able to buy a loaf of bread in the future.
A simple way to remember how to double your money is as the Rule of 72. It’s a quick way to estimate how long it will take your money to double. Put simply, divide 72 by your expected investment return rate, and that is the number of years it will take to double your money. For example, $100,000 earning six per cent will take 12 years to double: 72/6 = 12
Want to double check? Then recall the first example describing how to calculate compound interest, $100,000 earning six per cent over 12 years accumulates to $201,219. Yes, the rule of 72 works.
