Answer this question:
Would you rather have $10,000 per day for a month or one penny that doubled in value every day for a month?
If you chose the $10,000 per day, at the end of 30 days you would have $300,000. Oh…but you left about $5 million on the table. It may be hard to believe, but it is true. One penny today, two cents tomorrow; four cents the next day and so on, by the end of 30 days, you would have $5,368,709.12
The rate of return that is used in this example (100% per day) is not obtainable, but is nevertheless a good illustration of the power of compounding. Compound interest is interest earned on the original principal plus any reinvested interest. So each month when you are paid interest into your bank account or other investment, you are enjoying the benefits of compounding. Compound interest helps us save more to achieve goals like retirement, college, a dream home and more.
In my example, the interest is compounded daily. That won’t be an option. Popular compounding frequencies are monthly, quarterly and in some cases semi-annually. Choose the option that happens most often.
Since my example is extreme, let’s look at another that would be achievable:
Consider an individual, 30 years of age, with a retirement account balance of $20,000 that achieves an annual 6% rate of return. After 35 years (with no additional contributions) the original $20,000 investment, through the benefits of compounding, will grow to $153,722 by age 65. That’s more than seven times the amount of your account balance at age 30!
Please note that there are no guarantees for return rates or growth of principal and this example is for illustrative purposes only.
The following formula is effective for demonstrating the benefits of compounding over time:
FV = PV (1 + i)^N
FV = Future Value (the amount you will have in the future)
PV = Present Value (the amount you have today)
i = Interest (your annual rate of return or interest rate earned)
N = Number of Years (the length of time you invest)
So if you were not sure how compound interest works, now you know.
And if anyone asks you, take the penny.