Confounded by compound interest? You're not the only one
A compound interest lesson is important and worth repeating.
Rose, starting at age 20, puts $2,000 a year in a Roth IRA, putting the money in a diversified stock fund. She stops contributing at age 30 and never adds another cent. Carlos, waits until he is 30 to start, then puts in $2,000 a year in the same fund until he is 65.
Carlos contributes a total of $70,000 compared to $20,000 for Rose. But assuming an average annual compounded return of 8 percent, realistic if not conservative for a long-term stock fund investment, Rose would have accumulated $462,647 by age 65, compared to $372,204 for Carlos.
Why? With more time to let her money grow, Rose benefited from the power of compound interest.
A knowledge of compound interest is the most powerful motivator to get more Americans to save, according to a recent survey by the Consumer Federation of America. But based on years of federation research, "most people underestimate the power of compound interest by two-thirds," said Stephen Brobeck, the group's executive director.
The basic concept of compound interest is that the interest you make on your savings earns additional interest and that interest in turn makes more interest, and so on and on.
For example, if you deposit $100 in an account that pays 5 percent interest, you'll earn $5 and have $105 after one year. The second year, you will earn 5 percent interest not just on the original $100 but also on the $5 interest you earned the first year. That makes for a total of $5.25 in interest, bringing your account value to $110.25 after two years.
The term compound interest is also used broadly to refer to the compounding of any type of investment earnings, such as capital gains. If you invest $100 in a stock fund that returns 5 percent each year, you also will have $110.25 after two years.
That may not seem like much, but even at a 5 percent compounded return, money will double in a little more than 14 years.
For typical rates of return, you can use the "Rule of 72" to estimate how long it would take your money to double. Just divide 72 by the rate of return. If you earn 8 percent a year compounded, it would take about nine years. If you earn 9 percent, it would take about eight years.
The way the math of compounding works, most of the growth of a long-term investment occurs in the later years. Therefore, you must be patient. Just a small increase in return can make a huge difference in the long run.
For example, if you invest $100 a month for 30 years and earn 5 percent a year compounded, you'll end up with $83,226. But 8 percent gets you $149,036 and 10 percent, $226,049.
Conclusion: It pays to try to improve your rate of return. But don't take more risk than you can afford because a big loss can wipe out years of gains.
Humberto Cruz is a columnist for the South Florida Sun-Sentinel. He can be reached at askhumberto@aol.com.
