“The most powerful force in the universe is compound interest” – Albert Einstein
Take a minute to read the two questions below and estimate the answers. Don’t put too much thought in to it, or perform any calculations. Simply read the questions and write down your estimates:
- Starting on the day you are born you invest $1 per day (just over $30 a month) until you turn 65 years old. You average a 10% annual return on your investment throughout that time period. How much money will you have when you turn 65?
- You have $10,000 in credit card debt and your interest rate is 18%. Each month you make the minimum payment of the monthly interest plus 1% of the balance due. How many years will it take you to pay off the debt?
I will provide the answers at the end of the post but if you are typical you significantly underestimated the power of compound interest to both benefit and harm you.
Let’s look at one more example to prove this point. Imagine you have a sheet of extremely thin paper. How many times would you have to fold that paper in half in order to have a stack of paper tall enough to reach the moon? Write down your best estimate.
Now take a few minutes to watch this fascinating TED-Ed video that answers this question. It lasts less than 4 minutes: How Folding Paper Can Get You to the Moon
If you watched the video you learned that you would only have to fold a sheet of paper in half 45 times in order to have a stack of paper tall enough to reach the moon. How many folds did you estimate? Does it surprise you how low the correct answer is? The reason we are fooled by this problem is because the stack of paper grows exponentially, not linearly. This same principle gives compound interest its incredible power.
It appears our brains just aren’t wired to intuitively grasp the power of compounding. Unfortunately this weakness contributes to poor decisions and can have dire consequences for us financially. Since we underestimate the power of compound interest we borrow too much (we don’t grasp how much interest we will have to pay in the future) and we save too little (we fail to comprehend how powerful an ally compound interest can be when it is on our side). It’s a double whammy. Our poor estimating skills lead to decisions that keep us in debt and prevent us from unleashing the incredible power of compounding in our favor.
A better understanding of the power of compounding should lead to better financial decisions. In addition to the examples above another way to gain this understanding is by playing around with online financial calculators. Here are the links to the calculators I used to answer the questions posed initially:
- This calculator on Dave Ramsey’s website will help you grasp the awesome power of compound interest working in your favor: Dave Ramsey’s Investment Calculator
- This calculator on Bankrate.com will help you understand the true cost of credit card debt: Bankrate’s Credit Card Calculator
Play around with these online calculators for a few minutes and you will start to grasp the power of compound interest. You can even use these calculators to answer the questions posed initially. If you don’t want to calculate the answers, here they are:
- If you save a dollar a day starting from your birth, and are able to earn a 10% annual return, you will have just under $2 million ($1,963,747) when you turn 65. You will have contributed only about $24,000 of this total. The other $1.9 million is yours due to the magic of compounding.
- If you have $10,000 in credit card debt, the interest rate on your card is 18%, and each month you pay the minimum payment of the monthly interest plus 1% of the balance due it would take you over 28 years to pay the card off. During that time you would pay over $14,000 in interest.
What were your estimates? Did you underestimate the power of compound interest as most people do? I would love to hear how you did.
Hopefully you now have a better understanding of the incredible power of compounding. Now you need to come up with a plan to unleash it on your behalf instead of allowing it to drag you down and keep you captive.