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Infographic: Compound Interest Explained
Compound Interest Explained for Beginners
Thanks to compound interest, investing just $150 per month can turn into more than $1.1 million – and you don’t need to pick winning stocks.
But the same compounding will work against you – if you let it.
I passed the CFP® exam at 16 and have helped millions improve their finances over the last 8 years.
Here’s exactly what compound interest is without the jargon, how to take advantage of it, and how to stop it from working against you.
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Simple Interest vs Compound Interest
Most people’s understanding of interest comes from checking accounts and savings accounts.
Simple interest means you only earn returns only on your original deposit.
If you put $1,000 into an investment that returns 10% simple interest, and you earn exactly $100 per year, every year.
With compound interest, every dollar of growth gets added to the balance, so next year’s return applies to a larger amount.
This means that the first year, you get 10% of $1,000 which is $100, but the second year you get 10% of $1,100 which is $110.
It might not seem like a lot at first, but after some time you’ll be getting thousands of dollars every year in returns, and it only goes up every single year.
Because of this, time turns out to be the most important variable in the compounding formula, and the difference between starting to invest at 25 versus 45 is over a million dollars!
Compound Interest: Age 25 vs 45
Priya starts investing at 25 and puts in $200 a month for the next 20 years. Dan makes the same $200 a month investment in the same fund for 20 years – but he starts at 45.
When they turn 65, Priya’s investment is worth $1.2 million, but Dan’s is just $154,000.
They both invested $48,000 – the only difference is Priya’s 20-year head start. That’s what led to the most explosive compound growth.
Dan waited until he earned more, but that’s the trap. Starting with $50 a month now beats a perfectly planned $200 a month starting ten years later.
Compound Interest and Debt
When you carry debt, the power of compounding runs in reverse – because interest accumulates on your balance, and then the next day’s interest is calculated on that larger balance, not on the original amount you borrowed.
This is daily compounding, and it means your balance grows a tiny bit every single day.
On a $5,000 credit card balance at 22% APR, you’ll pay over $3,000 in interest if you only make the minimum payment since the minimum is way too low to meaningfully reduce your balance.
Here’s what you should do: try to pay more than the minimum.
If you pay triple the minimum, for example, then you’ll end up paying less than a quarter of the interest – just $690.
The next section covers the exact system to take advantage of compounding, and it only takes about ten minutes to set up.
How to Invest to Take Advantage of Compound Interest
You don’t need a financial advisor or a high salary to benefit from compounding. All you need is an automated system that removes all the decision-making from the equation.
An index fund is a single low-cost investment that lets you own hundreds of companies at once, so when the broader market grows, your investment grows with it.
So automate your investments into index funds.
A good starter setup is a 80/20 split between 2 funds: put 80% into VOO – which tracks the 500 largest US companies – and 20% into VEU, which covers international markets outside the US.
Setting up automatic investment takes less than ten minutes!
Schedule a transfer from your checking account to your brokerage account on payday, and set up automatic investment in these 2 funds for the same day, so the system runs completely without you.
But even after knowing about compounding, beginner investors are still making some easy-to-avoid mistakes.
Check this out to find out how to avoid 4 common beginner investing mistakes, and build more wealth over the long run: 4 Beginner Investing Mistakes That Are Quietly Costing You Thousands