You have probably heard someone mention compound interest at one point or another, at least I hope. Either way, we’ll do our best to catch you up on the topic and even provide you with an awesome tool to help out!
The basics of compound interest
According to Investopedia, compound interest (or compounding interest) is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. So what does this mean for you? Let’s take a look at the example below.
| Year 1 |
|---|
| Savings deposit: $10,000 |
| 3% interest in first year: $300 |
| Year 2 |
|---|
| Starting balance: $10,300 |
| 3% interest: $309 |
As you can see, in year 2 you made $309 in interest, vice $300. This is because the previous interest was now earning its own interest. Pretty cool, huh? Keep in mind these increases can be really substantial when balances exceed $100k.
How do I calculate it?
In my example above I used simple numbers, so the math was pretty easy. But it gets more difficult when using different compounding frequencies, i.e. monthly, or semi-annually, etc., or when using large amounts of money with additional contributions. Because of this, you should use a trusted compound interest calculator that works for you.
I introduce to you the Compound Interest Calculator, brought to life by Wealthy Idiots Co-Founder AJ Sheff. This handy tool will help you run those complex calculations without breaking out your phone calculator or the spreadsheet. Simple, right? If you need more of an explanation on this in general, AJ Sheff explains it in detail in this YouTube video, giving you all of the good stuff I can’t fit in this article.
Applying this principle to stocks
Does the theory of compound interest translate 100% to the stock market? No. Stocks don’t pay “interest” so you wouldn’t have the continuous reinvestment occurring. However, some stocks do issue dividends which can be reinvested and simulate the same type of compounding as simple savings.
With that said, our compound interest calculator can absolutely be used for stock market appreciation as well. Think of it this way:
You have $10,000 in stock in year 1. The stock increases by 3% to $10,300. In year 2, the stock that was $10,300 increased by another 3%, which would put it at $10,609, the same end result as the example above. It’s a wash, right?
Not exactly. While there is no risk of losing the interest earned in the savings account, there is absolutely risk in losing the value of the stock. Markets can fluctuate significantly and impact your performance. Just keep this in mind as you’re assessing the level of risk that is right for you.
Applying this to your personal situation
I am constantly running compound interest calculations. This is a quick way of running various scenarios while you’re trying to make investment decisions, plan for a big pay raise, or just planning for retirement 30 years out.
Additionally, you can make a spreadsheet that updates your progress from year-to-year (Note: we’ll eventually bring this function to the site, but it will be a bit!) Personally, I use the future value (=fv) formula in Google Sheets to forecast all of my future growth. This works great for keeping tabs on my various investments while also sticking to my plan. There are several good YouTube videos that can help you set this up if you are a beginner when it comes to spreadsheets.
Key takeaways
After reading this, I hope you’ll have a new found appreciation for compound interest. When I learned this around 8 years ago, it was like a light switch flipped. Keep tabs on your progress and keep forecasting the growth of your wealth, your 60 year old self won’t regret it! Oh yeah, don’t forget to check out our Compound Interest Calculator.
