Compound interest is a force to be reckoned with—its power is pretty amazing. It explains why the money you invest today—even a seemingly modest amount—can go so much further than the same sum invested years later.
You’ve probably heard that you should start saving and investing as early as possible, especially for retirement. That sounds like good advice, but we all have other financial priorities. That’s especially true for younger people dealing with mounting student loan debt, higher housing costs, and stagnating salaries. Why is it really so important to put money into the market sooner rather than later?
Because the longer you invest, the more time you have to weather the inevitable ups and downs of the stock market. And the more time your earnings have to compound.
Below, we describe exactly what compound interest is and how it works. Chances are this knowledge may make you want to be the early bird that catches the worm when it comes to investing.
What is Compound Interest?
There are two ways to calculate interest. With simple interest, interest is calculated only based on the original amount of the loan or investment (known as the principal). With compound interest, however, interest is calculated based on the investment principal, as well as on the interest you’ve earned to date. As you can imagine, essentially earning interest on your interest allows your money to grow faster.
For example, as a hypothetical scenario, if $5,000 is invested and receives 10% interest that compounded annually, after the first year, the account would earn $500. But starting with the second year, the 10% interest would be calculated based on the new amount of $5,500, not just the original $5,000.
The numbers add up quickly. After 10 years, the account would be worth around $12,9701. (If you want to see how this works for yourself, an online compound interest calculator can generate hypothetical results depending on the initial investment, interest rate, additional contributions, and length of time.)
How to Compound Interest
If you want to get technical, there’s a compounding interest formula you can use to calculate returns:
A = P(1+r/n)nt
Let’s break this down. “A” is the final amount of money you’ll end up with. “P” is the principal, or original amount invested. The “r” is the interest rate as a decimal, so 0.1 for 10%. The “n” is the number of times interest compounds each year, and “t” is the number of years you’re looking at.
The “n” in the formula above—how often interest gets compounded—makes a big difference. If interest is compounded monthly instead of yearly, for example, that can really change things.
Why Making Additional Contributions Matters
While investing early helps you take advantage of compound interest, so does investing regularly. If you make additional contributions each year on top of your initial investment, compounding interest has the chance to go even further.
Getting in on compound interest doesn’t mean you need to have $5,000 to invest today. Even small contributions can make a difference. The earlier you start investing and the more time you have, the more of a chance compound interest has to work its magic.
To illustrate, let’s revisit the equation above with a smaller hypothetical initial investment. Let’s say $500 is contributed to a retirement account today, compounded annually at 10%, and nothing else was done for 10 years. At the end of that time, the account would have:
A = 500 (1+0.1/1)(1*10)
A = 500 * 1.110
A = 500 * 2.5937424601
A = $1,296.87
But if you have 40 years, you get a different answer:
A = 500 (1+0.1/1)(1*40)
A = 500 * 1.140
A = 500 * 45.2592555682
A = $22,629.63
That’s quite a jump! And all it took was time.
If you were also to add just $50 a month to that initial $500 contribution, you’d have around $10,860 in 10 years. And after 40 years? You’d have $288,185.1 Even investing small amounts, especially consistently over time, can pay off, depending on the rate of interest, compound interest.
Taking Advantage of Compound Interest with SoFi Invest®
If you want to start making compound interest work for you, you can begin online investing today through SoFi Invest. You can get started with as little as $1.
You can invest through a retirement account (traditional, Roth, or SEP IRA) or through an after-tax account. Your funds will go into a portfolio of Exchange-Traded Funds, a lower-cost and more diversified investing strategy.
SoFi’s credentialed financial advisors will rebalance your portfolio at least quarterly to make sure it matches your risk tolerance and investment trajectory.
Choose how you want to invest.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile.
1IMPORTANT: The projections and other information included above regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Advisory services offered through SoFi Wealth, LLC a registered investment advisor. SoFi Securities, LLC, member FINRA / SIPC .