Anyone who has ever owned a CD, savings or money market account is familiar with the fundamental concept of earning interest. What many people fail to fully comprehend, however, is the distinction between “simple interest” and “compound interest,” and more importantly the profound difference the latter can have on your ability to accumulate more wealth.
With simple interest, how much you will ultimately earn on your money is a straightforward calculation that’s solely dependent on three variables: the amount you invest; the interest rate you’ll receive; and the length of time you invest your money for.
For example, a $100,000 investment in a 10-year bond paying a simple 5% annual interest rate would earn you $5,000 in interest each year, or $50,000 in total accumulated interest upon maturity ([$100,000 x .05] x 10). At the end of the ten years, your original investment would therefore be worth $150,000.
Conversely, the same $100,000 investment in a 10-year investment paying 5% interest compounded annually would not only earn interest on the principal amount invested, but also earn interest on the interest paid in previous years as well. This enables your money to grow considerably faster. Rather than being worth $150,000, the same investment earning compound interest would have grown to almost $163,000.
Much like a snowball increasing in size and speed, the more time the power of compounding has to work, the more dramatic its effect. Using the same example as above, after 20 years the simple interest account would have doubled to a value of $200,000 whereas the account with compounding would be valued at $265,330 (nearly one-third more). In 40 years, the simple interest account would be worth $400,000 while the compound interest account would be worth over $700,000. When it comes to the power of compounding, time really IS money!
Adding investment growth to the equation
Now, rather than a principal amount that never changes, imagine you apply the same power of compounding to a portfolio of investments that could also be growing in value at a competitive market rate. What results is the financial equivalent of supercharging an engine.
For the 20-year period from December 1996 until December 2016, the S&P 500® (with dividends reinvested) increased by an average of 7.6% annually. Keep in mind that this timeframe includes the devastating impact of the 2008 financial crisis in which the index lost more than 36% of its value. Yet a $100,000 investment that earned a market return and had dividends reinvested would have grown in value to $435,376 thanks to the incredible power of compound growth.1
With compounding, you receive interest not only on your original investment, but also on all interest, dividends and capital gains that accumulate. As the years go by, your money can grow faster and faster, especially in retirement accounts where growth is either tax-deferred as in traditional IRAs and employer-sponsored plans or tax-free as in Roth IRAs because Roths are funded with post-tax dollars.2 In all cases you need time, a commitment to reinvest any account earnings (or even better, to periodically add to your original investment), and a fair amount of patience. This example is for illustration purposes only as past performance is no guarantee of future results.
Whether you’re putting money away for retirement, a child’s education or another long-term goal, talk to your SunTrust advisor about how the power of compounding can turn even a modest monthly savings into a sizable nest egg over time.