Understanding Compound Interest: How It Can Work for You

Presented by Weller Financial Group

Compound interest is one of the most powerful concepts in personal finance. Simply put, it is interest earned on the money you invest or save, plus interest earned on the interest you’ve already accumulated. Although it may sound complicated at first, compound interest is actually a straightforward and powerful tool that can significantly grow your wealth over time. Let’s break it down and explore how compound interest works in your favor.

What Is Compound Interest?

Compound interest is the interest you earn—not just on the amount you invested, but also on any interest that’s already been added. It’s like a snowball rolling downhill—over time, your investment grows faster as the interest is added to your balance and earns more interest. This is different from simple interest, which is calculated only on the original amount invested.

Simple Vs. Compound Interest

• Simple interest: You earn interest only on the initial amount you invested. If you invested $1,000 at a 5 percent annual interest rate, for example, you’d earn $50 each year. After three years, you’d have $1,150 (your $1,000 investment plus $150 in interest).
• Compound interest: You earn interest on both the original investment and any interest earned. Using the same $1,000 at 5 percent compounded annually, you’d earn $50 in the first year. In the second year, you’d earn interest on $1,050, which is $52.50. By the third year, you’d earn $55.13 on the new total of $1,102.50. After three years, your balance would grow to $1,157.63, a greater amount than with simple interest.

Why Does Compound Interest Matter?

Compound interest helps your money grow faster than simple interest. The longer your money is invested, the more significant the impact of compound interest is. The key to success is time: the earlier you start the more compound interest can work for you.

The Power of Time

Let’s look at two scenarios:

1. Starting early: Jane invests $5,000 at age 25 in a retirement account that earns 7 percent annual interest. By the time she turns 65, her investment grows to $74,872.29.
2. Starting late: John invests the same $5,000 at age 40, also earning 7 percent annual interest. By age 65, his investment grows to only $27,137.16.

This is a hypothetical example and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results.

The difference is the number of years the money has to compound. Jane's investment grows over 40 years, while John’s grows over just 25 years. Even though they started with the same amount and earned the same rate of return, Jane’s earlier start gives her a significantly larger balance.

Compound Interest vs. Compound Returns

While compound interest focuses on the growth of your money through interest alone, it's important to understand the difference between compound interest and compound returns. Compound returns include not only the interest you earn, but also any extra earnings from things like the increase in the value of your investments or profits that get added back to your account. For example, if you invest in stocks or mutual funds, you can earn both interest and a portion of the company's profits, which can be reinvested to help your investment grow more. While compound interest only refers to the interest on your initial amount, compound returns look at the full growth of your investment, including both interest and any extra earnings. Both ideas work by reinvesting what you earn to help your money grow faster, but compound returns apply to a wider range of investments, not just savings accounts.

Everyday Examples of Compound Interest

You don’t need to be a financial expert to see compound interest in action. Here are common scenarios where you can benefit from it:

1. Savings accounts: Although interest rates may be lower, many savings accounts still use compound interest. Over time, even small amounts can grow significantly.
2. Retirement accounts: Accounts like 401(k)s or IRAs take advantage of compound interest to build your retirement savings. The earlier you start contributing, the more your money can grow.
3. Investment accounts: Stocks, bonds, and mutual funds allow your investments to compound. Any dividends or interest earned can be reinvested, creating a snowball effect.
4. Credit cards: Compound interest can also work against you. Credit cards charge interest on your outstanding balance, including interest that has already been added. This is why carrying a credit card balance can be financially damaging over time.
5. Mortgages and loans: Even though fixed payments may seem predictable, compound interest is at play behind the scenes. The longer it takes to pay off a loan, the more interest you’ll ultimately pay.

Maximizing the Benefits

To truly take advantage of compound interest, focus on two key factors: time and consistency.

• Start early: The earlier you begin saving or investing, the more time your money has to grow through compounding. Even small amounts can add up significantly over many years.
• Be consistent: Regular contributions, whether monthly or annually, help accelerate your growth. Consistently adding to a retirement account, for example, lets interest compound on a larger balance, making your money work harder for you.

Compound interest is a simple yet powerful tool that can help you build wealth over time. Whether you’re saving for a big purchase, building an emergency fund, or planning for retirement, understanding how compound interest works can significantly boost your financial growth. The earlier you start, the more your money will grow. Be patient, stay disciplined, and let time and compound interest do the heavy lifting.

Investments are subject to risk, including the loss of principal. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.

Weller Financial Group is located at 6206 Slocum Road, Ontario, NY 14519 and can be reached at 315-524-8000. Advisory Services offered through Commonwealth Financial Network®, a Registered Investment Adviser.