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. You’ve probably heard the saying, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” (It’s widely attributed to Albert Einstein, but researchers have found no evidence this quote existed during Einstein’s lifetime, with the first known print appearances coming only decades after his death. The “eighth wonder” framing traces back at least to a 1925 bank advertisement, with no attribution at all.) Whoever coined it, the underlying idea is genuinely powerful.
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, and that you’d earn the same rate of return every year, which is unlikely.)
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.
The bottom line is the same whether you’re saving or borrowing: understanding how compounding works — and working with it rather than against it — is one of the most valuable financial skills you can have.
