April is Financial Literacy Month so I’m writing about general financial topics this month. Today’s topic: the power of compounding.

The power of compounding is what makes long-term savings so beneficial. It’s also what makes debt so costly. As Albert Einstein (yes, that Albert Einstein) said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Compound growth is the process by which an initial investment earns a return, and then the return earns its own return. It’s how $1,000 becomes $2,000 or $10,000 or $50,000.

Here’s an example. Let’s say you invest $1,000 in a fund with an average return of 8%. After a year, you’d have $1,080, which is great. But what’s even better is that now you’ve got $1,080 earning 8%. So the next year, you’d have $1,166.40. And after 10 years, you’d have over $2,100. Suppose you invested that $1,000 in a 529 when your child was born, and it grew 8% annually for 18 years. When they finish high school, that $1,000 would be worth $4,000.

If they invested $1,000 in a Roth IRA when they graduated from college and earned that return for their working years, they’d have almost $30,000 when they retire.

Of course, if you continue contributing along the way, you’ll end up with even more. Let’s say you invested $1,000 every year for 18 years and earned 8% annually. You’d have more than $40,000 at high school graduation.

The power of compounding is why investing early is so important: the more years your savings has to compound, the larger your balance is likely to be. The principle applies to college savings, retirement savings– really, any long term savings. The sooner you start, the more work your money does, and the less work you have to do. For example, if you want to have $40,000 available for college when your student graduates from high school, here’s what you would need to contribute at different starting ages:

  • Newborn: $1,000 per year or $10,000 initially
  • 5 years old: $2,000 per year or $15,000 initially
  • 10 years old: $3,500 per year or $22,000 initially
  • 14 years old: $7,000 per year or $30,000 initially

(These numbers are hugely simplified, assuming for example that you’d pursue a fairly aggressive investment strategy all 18 years, which would not be prudent.)

Compounding can work against you too. For example, student loans accrue interest during the college years and that interest is capitalized, or added to the loan principal when the loan goes into repayment– meaning that you pay interest on your interest. That’s why it’s beneficial for recent college graduates to start making payments on loans as soon as they’re able, regardless of whether they’re still in the grace period. And of course, income-driven repayment plans accrue interest which can be capitalized in some circumstances.

Big news: I wrote a book! You can pre-order How to Pay for College from Barnes & Noble, or find it at your favorite bookstore in July.