Compound Interest: The Eighth Wonder of the World

A mistake millions of consumers make is underestimating the power of compound interest. The average household in the United States has over $12,000 in credit card debt. By just making the minimum payment on a credit card balance of this size, it could take over ten years to pay off the balance. A significant portion the credit card debt of many consumers is the interest on the interest that has accumulated, otherwise known as compound interest.

Luckily for us compound interest works both ways.  Bank money market and savings accounts can utilize the power of compounding to increase rates of return. In fact, all your income including dividends, bond interest, CD interest, or even payroll income should be deposited in accounts which compound interest.

Interest Rates Really Are Interesting

"Yeah, interest. It's an amazing thing. You make money without doing anything..."

"Y'know, I have friends who try to base their whole life on that principle."

"Really? Who?"

"Nobody you know..."

Jerry and George - Seinfeld TV Show

Banks are willing to pay us on interest on our money. All things being equal the more often a bank compounds interest, the better it is for us. This means daily compounding is better than weekly compounding and quarterly compounding is better than annual compounding. Fortunately we don't have to make intricate calculations on each bank rate we see to compare th effects of compounding. The annual percentage yield (APY) quoted by banks factors in compounding to make an apples-to-apples comparison of bank rates which have differing compound periods.

Households with credit card debt will be losing the fight against compound interest any month that their card payment does not at least meet the interest rate charges for that particular month. Remember the minimum payment listed by the credit card company on your statement is not always the minimum amount needed to be paid to prevent your credit card balance from increasing due to compounding.

With investment accounts it is advisable to make sure that all interest earned on a Treasury security, bond, CD, or other fixed-income investment is automatically swept into an account earning interest. This is not always the case with brokerage accounts and bank accounts, so financial planning is sometimes needed to maximize the magic of compound interest. Even with interest rates at 1% and 2% on some accounts, the effects of compounding interest should not be overlooked.

The Rule of 72

The often-quoted rule of 72 says that the number of years it take to double your money is 72 divided by the rate of return. This is of course an oversimplification that doesn't take into account taxes or investment risk, but it is a good demonstration of the power of compounding. For instance, after the stock market decline of 2008-2009 investors who owned an S&P 500 index fund over the last 12 years have earned 0%. During the same time period it would have only taken an annual return of 6% for an investor to double their money in a fixed-income product like a bank CD.  Not too many investors could have been convinced in 1997 that the CD investor would have doubled up the S&P 500 investor.

The Millionaires Estimation

Another financial tool based on compound interest is the millionaire's computation. This calculation asks the question: How much money will I need to set aside a year to have saved $1,000,000? The answer will vary as the average annual interest rate is changed. But just for kicks, a person stating from scratch at age 30 would have to set aside $700 a month earning 6% a year until the age of 65 to accumulate the $1,000,000. Of course the millionaire's estimate does not factor in inflation - the sworn enemy of compound interest.