Do you know the difference between simple-interest and compound-interest? You’re probably scratching your memory, thinking to yourself, “I know this; I learned this in a basic high school econ class.” You’re right; you did – we all did – but few people remember just how powerful a tool compound-interest is and why they should make sure it’s working for them in their investment accounts.
Most of the time, when we talk about “interest”, we are referring to simple-interest. Simple-interest is basically a fixed percent payment on your original principal balance.
For example, if you loan a friend $1,000 on a 10-year loan with 12% simple-interest, you’ll receive $120 interest each year, and at the end of those 10 years, you will have been paid 10 years of interest plus your original $1,000. In total, you’ll receive $2,200 (your principle balance of $1,000 plus the $1,200 earned in simple-interest over those 10 years).
Table 1 below shows the cumulative interest for each year and the growing value of the original loan amount plus the interest paid up to that point.
Table 2 shows what happens if your interest is calculated on a “compound” basis. Notice how much more you would receive at the end of the 10 years. The difference starts small – none in the first year, a small amount in the second year, and a huge difference by the time you finish.
That huge difference is what has allowed investors, like Warren Buffet, to amass huge fortunes from investing. That huge difference is also what prompted Albert Einstein to say, “compound-interest is the eighth wonder of the world. He who understands it, earns it … He who doesn’t … pays it.” Here’s why.
Let’s say you loaned that same $1,000 to a friend at 12%, but this time asked that the interest be calculated and paid on a “compound” basis. At the end of the first year, your friend would owe you the same $120 in interest as he or she would have on a simple-interest basis. With compound-interest, however, the first year’s interest owed would be added to your original principal. So, the loan would have increased to $1,120. For the second year, the interest charge would be 12% of that larger $1,120 amount.
Do you see the difference? With simple-interest, the second year’s interest is the same as the first year’s interest. They’re both $120.
But with compound interest, the first year’s interest charge is $120, but the second year’s interest charge is $134.40
In a compound-interest situation, each year’s interest charge is added to the previous balance to form the basis on which the next year’s interest is calculated.
Applying Compound Interest In Investing
It’s a little complicated to explain in writing, so look back up at tables 1 and 2. Notice how the cumulative interest and the cumulative total is growing faster in table 2 (compound-interest) than it does in table 1 (simple-interest)
How does this apply to your investment portfolio? Well, instead of using the example of a loan you made to a friend, apply the same concept to an investment portfolio. If you have the choice between earning 12% per year on a simple-interest basis or earning it on a compound-interest basis, you’d be wise to choose compound-interest every time.
The graph below illustrates this. In our hypothetical $1,000 investment example, compounded interest earnings over the 10-year period produces $906, or about 75%, more than a simple-interest investment would produce.
As you can see, time plays a huge part. The graph shows us that during the first 3 years, there’s hardly a difference; in the 4th and 5th years, the difference starts to become more obvious; and in the 6th through 10th years, the compound-interest investment takes off.
The exponential growth of compound-interest is even more profound when you extend this concept over longer periods. The numbers can be staggering.
An initial investment of even $10,000 compounding at 10% over 50 years would grow to a staggering $1,173,908!
The last question you’re probably asking yourself is, “don’t all stock market investments provide compound growth?” The answer is, no!
You have the choice of reinvesting your interest and dividends as they are earned each year. That’s the decision you make as to whether to use “simple-interest” or “compound-interest”.
If you choose to have your dividends and interest paid to you each year, you have chosen simple-interest.
If you choose to have your dividends and interest reinvested, you have chosen compound-interest.
The difference over the last 50 years of the Dow Jones Industrial Average (October 19, 1968 to October 18, 2018) was, drum roll please:
6.881% per year without dividends reinvested
10.546% per year with dividends reinvested
Remember, there are no guarantees that the Dow will produce the same returns in the future, and there is certainly a lot of volatility along the way. But the truth remains that you have a choice to make between using simple-interest and compound-interest, and that choice can have a huge impact on whether you’re ready for retirement.
If we can help you decide how much to invest in stocks vs bonds or other investment opportunities (or if you want to revisit that decision), we would be honored to help. We are committed to helping clients make the right choices for their future and ultimately to achieving their financial goals.