A lot is said about compound interest. It’s often called the eighth wonder of the world and Albert Einstein allegedly referred to it as the “greatest mathematical discovery of all time”.

But…what is it, exactly?

ALSO READ: How to invest your first $500

Okay – well let’s start with interest. We all kind of understand what that is. When you borrow money, you pay interest. It’s like…the rental fee for money. If you’re a lender, then you’re paid interest for providing your capital. Interest is often quoted as a percent of the capital on loan. So if you borrowed $50,000 from a bank then you might have to pay 4% interest, or $2,000, on that every year. If you borrowed it from a shady loan shark you might have to pay $2,000 every two weeks.

Now compound interest is what happens when interest has the chance to build on itself over time. Compound interest can be positive, like when you keep your money in a retirement account for thirty years. It can also be negative, like when you rack up massive credit card debt and only pay off the minimum balance every month. In each case, interest is accrued and is added to the underlying assets, or principal. Over a long enough time period, that interest builds up higher and higher…until you’re looking at either a very cushy nest-egg or an intimidating credit card bill.

Think of it this way: What if your goal in life was to become a better guitar player and you just focused on becoming 1% better every day?

Improving by 1% doesn’t sound like very much. While it may not be super sexy right away, check out what happens when you keep at that daily practice. What if you kept at it for one full year?

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Well, if you improved 1% every day for a year, you would have improved by more than 365%. That’s right, it’s not as simple as adding 1% every day for 365 days. That’s why compound interest is so…magical. If you started with $1 and added 1% every day for 365 days, you’d end up with nearly $38. That’s a 38-fold improvement, and that’s the magic of compound interest.

Be careful, though.

Here’s where you have to watch out:

See, compound interest is one of the staples of personal finance. Almost everyone that talks about personal finance and wealth accumulation or retirement planning will invoke the magic of compound interest. And while it’s true that compound interest is definitely a powerful force, one has to question the underlying assumptions of the invokers.

For example, many people will tell you retirement is as easy as investing $X for Y years at Z% interest compounded.

“Just put $5,000 away every year and you’ll have about eleventy bajillion dollars in 30 years given an 8% interest rate. That’s the magic of compounding!”

Okay, we have to realize that the big assumption here is that you’ll earn 8% a year…for 30 years. Who says you’ll even come close?

compound interest

You also have to understand whether that 8% is taking inflation into account. Your money could grow by 25% every year, but if inflation is 30% a year…well then have you really made any money? If that were the case your money would buy less in the future than it could have today.

Most people who talk about compound interest and retirement in this manner are quoting nominal interest rates (i.e. interest rates that do not consider inflation at all). No, when we talk about returns we really need to talk about “real” interest rates (the nominal interest rate minus inflation). Real interest rates offer a better picture of purchasing power (what you can do with your money in the future).

From 1986 – 2016, a thirty year period, the S&P500 saw an annualized return of 7.5%. Inflation reduces that return to 4.8%.

If that doesn’t sound like a big enough deal then listen to this: it’s not just about how much money you have at the end of your investment time horizon. It’s also about how much you can buy with it. If you invested $5,000 and earned 7.5% in real interest, you’d have about $44,000 at the end of thirty years. If you earned 4.8% in real interest you would have $21,000…Less than half.

That’s why you have to be careful.

If you’re not vigilant you could be fooled into thinking that planning for retirement is as easy as sticking your money into an index fund and taking a thirty year nap.

In truth…the real return from investing in the S&P500 varies widely depending on when you enter the market. From 1871 to 2016 the U.S. stock market has only returned a real interest of 2.2%. That’s not inherently bad, though! We have to put it into context, because we don’t know what the other alternatives would have netted us. You could have made 7.5% investing in stocks over the last 10 years…but what if bonds returned 10%? Did you do as well as you could have?

So the bright side is that if you invest in stocks, and reinvest the dividends, you tend to do a lot better. From 1950 to 1980 an investment in the S&P500 returned 2.3% annually but that figure rises to 6.5% if you reinvest your dividends.

The takeaway

If you come away with anything after reading let it be this: don’t take anything for granted. Compound interest is fantastic and you really want to get your money invested as soon as possible so you can let the long hand of time work its magic. We just want to make sure that you don’t get fooled into thinking that riches are guaranteed. You still have to do your homework!

Commit yourself to a life of learning about investing and personal finance and you’ll do fine in the long run.

compound interest

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