The Power of Compound Interest: What It Is, How It Works

Compound interest is a key wealth building principle. When you place money into a savings vehicle or investment that money will earn interest on the amount you invested. Compound interest is the process in which the money that you invested earns interest on both the initial investment amount and the previously earned interest. This creates a compounding effect making your money grow at an accelerated rate.

Assume that you are going to invest $100 into the stock market at the beginning of the year. To also keep things simple, assume that you can earn a 10% return on that investment. You invest the $100, wait a year, and at the end of year 1 you have $110 thanks to your 10% return on your initial investment of $100.

Now you are at the beginning of year two. Instead of selling your investment and taking your profit, you decide to leave it invested for another year. You are starting year 2 with a $110 investment. Assume you can earn another 10% return. At the end of year 2 your investment is now worth $121 thanks to another 10% return.

The longer you were to leave your $100 invested, the more money you would make. For example, say you were to leave this $100 invested for 30 years and continue to get an average return of 10% per year. At the end of the 30 years, you would have $1,745.

Compound interest made you $1,645 off your initial $100 investment. The best part? You did not have to lift a finger. All you had to do was leave the money invested. Compound interest continued to grow that $100 by adding on more interest each year.

Compound interest sounds great, and it is. However, investments do not go up every year - especially if you invest in the stock market. Some years you will get a positive return, some years a neutral return, and some years a negative return.  

If you hold on to investments through the bad times, they tend to recover. If you abandon ship when your investments go down, you will never experience the power of compound interest. The time it takes for investments to recover can sometimes be years, so just be patient.

It is also important to understand that the historical average returns that investments provide are not always their actual return. If compound interest grows your money at a lower return than the average, you will have less money. We will dive further into this topic below.

It is important to understand the difference between the average return on your investments vs the actual return. Your actual return is the return that compound interest uses to grow your money. For example, say that you were going to invest in a mix of index funds and mutual funds that were made up of stocks.

You have probably heard that the average return of the stock market as a whole is around 10% per year over long periods of time. For example, say that you put $5,000 into this portfolio. In year 1 the portfolio went up  20%. In year 2 the portfolio went up another 25%. In year 3 the portfolio went down 15%.

This would leave you with an average return of 10% over those three years (20% + 25% -15%)/(3). However, you need to take a closer look at what happened to see your actual rate of return.

1) Year 1 - In year 1 your initial $5,000 grew by 20% which would leave you with a balance of $6,000.

2) Year 2 - In year 2 your $6,000 balance grow by another 25% which would leave you with a balance of $7,500.

3) Year 3 - In year three your $7,500 balance went down by 15% would leave you with a balance of $6,375.

The total amount of money your account earned over the three year period is $1,375. Your actual return over the three year period is just over 7.6% ($1,375/3)/($6,000). This is a 2.4% difference when compared to the average return.

If you assume that compound interest is growing your money at the average rate of return, you will end up with less money in your account than anticipated. Let's look at another example to prove this. Assume that you have $10,000 to invest. To keep things simple, we are going to look at a hypothetical scenario over a 5 year period.

1) Year 1 - In year 1 your balance goes up 20%.

2) Year 2 - In year 2 your balance goes up another 9%.

3) Year 3 - In year 3 your balance goes down 18%.

4) Year 4 - In year 4 your balance goes up 9%.

5) Year 5 - In year 5 your balance goes up another 15%.  
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Your average return on your initial investment of $10,000 during this time is 7%. If you were to purely apply this average return of 7% to your account during this time, you would have $14,025 as indicated by the chart below.

However, your actual rate of return is lower than the average return of 7%. Let's look to see what actually happened with your money.

1) Year 1 - In year 1 your initial $10,000 grew by 20% which would leave you with a balance of $12,000.

2) Year 2 - In year 2 your $12,000 balance grow by another 9% which would leave you with a balance of $13,080.

3) Year 3 - In year 3 your $13,080 balance went down by 18% would leave you with a balance of $10,726.  

4) Year 4 - In year 4 your $10,726 balance grew by 9 which would leave you with an account balance of $11,691.

5) Year 5 - In year 5 your $11,691 balance grew another 15% which would leave you with an account balance of $13,445

This would make your actual rate of return just over 6.8%. This seems like a trivial difference, but results in a difference of $580 when compared to the average rate of return of 7%. Over time, this discrepancy would only grow larger given the same conditions.

What's the point here? The point is simply to understand that compound interest is a powerful financial tool, but that your actual rate of return is often less than your average rate of return. For example, let's assume that you were trying to save for you retirement through a retirement account such as a Roth IRA.

You decide to hold investment funds, such as ETFs and index funds, in the account. You assume that you can get an average return of 10% on these investments. You plan to invest in the account for 30 years with a monthly contribution of $550. If we apply the average rate of return of 10%, you will have $1,085,660 as indicated by the chart below.  

As you should understand by now, your actual rate of return can differ from your actual rate of return. Let's go through the same scenario as before. You are still going to invest $550 every month to save for your retirement in 30 years. However, your actual rate of return during this period is not 10%, but instead 9%.

Simply by dropping your return a single percent, you would now only have $899,629 as indicated by the chart below.

This is a difference of $186,031 when we compare it to the average rate of return generated. Make sure to understand that the average rate of return that investments provide, does not always mean that is your actual return. If you try to do compound interest calculations to figure out how much money you will have in the future, you will be frustrated if you do not end up with as much as you thought.  

You always want compound interest to be working in your favor. Common compounding vehicles are high yield savings accounts, 401(k)s, Roth and Traditional IRAs, and brokerage accounts. Anything that allows your money to be compounded can get compound interest on your side.

On the flipside, compound interest can also work against you. For example, let's say that you are not able to pay off a credit card balance. Interest will be added to your balance. If you do not pay off the balance in month two, more interest will be added onto your previous balance which already had interest added on.

This can cause your credit card balance to skyrocket, which is not want you want. The point here is to get compound interest working for you and not against you.  

It depends on your definition of rich, but the answer is most likely yes. Without the power of compound interest, the average every day investor would not be able to build wealth. With that being said, there are a couple of caveats to getting rich with compound interest.

1) Compound interest takes time - You cannot expect to invest today and wake up tomorrow experiencing the power of compound interest. Compound interest takes years to work. If you were to invest for 30 years to save for your retirement, there would not be much compound growth in the early years.

It would probably take around 20 years before you truly started to see compound interest working for you. This can be a tough bullet to swallow as it can feel as if compound interest does not work at first. But if you give it plenty of time, it will show up.  

2) Returns vary - The returns that allow compounding to be possible will vary. This is especially true if your investments are subject to volatility, such as stocks. Some years you could experience a 25% return and the following year a 20% loss.

If you bail during the losses, you never allow your investments to recover. Even though returns will vary, compound interest will work if you keep investing during the bad times. As previously stated, it is also important to understand that the actual return of investments differs from the average return of investments.

If you invest in stock investment funds with an average return of 10%, your actual return might be 9%. As you invest, understand that compound interest grows your money based upon the actual return of your investments and not the average return. If you do not understand this, you can end up with less money than anticipated.

3) Higher returns means more money - This should be an obvious one, but higher interest means you will make more money. If your money compounds at 8%, you will have more than you would if your money were to compound at 5%.

If your goal is to have compound interest make as much money for you as possible, you can invest in higher risk asset classes as they tend to provide higher returns. The tradeoff here is that you take on more risk as you invest.

What it really comes down to is your risk tolerance. If you are comfortable with more risk, you can invest in higher risk assets that may offer a higher return. If you are not as comfortable with risk, you can invest in lower risk asset classes that provide a lower return.

4) Lower your risk with diversification - If you only invest in a single stock, compound interest is less likely to happen. For example, let's say that you invested all of your money into Tesla stock. The return that Tesla stock provides can be all over the place. Compound interest is less reliable if you only have a single investment.

Instead of investing in just Tesla stock, you could invest in lots of stocks through an index fund. An index funds invests in lots of individual stocks at one time. You can buy a share of an index fund and get exposure to lots of stocks all at once.

An index fund would be less reliant on a single stock. If one stock goes down, another stock in the fund might be going up. This process is known as diversification. It makes compound interest more dependable as you are not reliant on a single stock to provide the return that compound interest uses to grow your money.

The bottom line is that compound interest is a process in which your previous investments that earned interest earn more interest on the base investment and previous interest earned. Compound interest is a key financial principle that allows your money to grow at an accelerated rate.

Keep in mind that compound interest is not a one night magical pill. It takes years to start working so it is important to be patient. The actual rate of return that you get is what compound interest uses to grow your money and often differs from the average rate of return that investments have historically provided.

If you want to see the effects of compound interest you need to stay consistent with your investments through good times and bad. The returns you get will fluctuate, but if you keep investing through the bad times compound interest will work on your behalf.