Compounding Interest The 8th Wonder of the World
I remember the first time I saw Niagara Falls. I was 12 years old and truly amazed with the magnitude and power of the waterfall. I could really see why this is considered by some to be one of the seven natural wonders of the world. Albert Einstein has famously quoted “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”[1] Einstein knew a thing or two about mathematics and I would agree with him. Like the first time I saw Niagara Falls, I had the same sense of awe once I learned about the power of compounding interest.
[1] Andrew Withers | Madison Business Review. “Compound Interest: ‘the Eighth Wonder of the World’.” The Breeze, 16 Apr. 2021, https://www.breezejmu.org/business/compound-interest-the-eighth-wonder-of-the-world/article_11a24ebe-9e77-11eb-ba00-33aaec328747.html.
So, what really is compounding interest? And why does the father of string theory call it a wonder? Mathematically speaking, “Compounding is the ability of an asset to generate earnings, which are then reinvested or remain invested with the goal of generating their own earnings. In other words, compounding refers to generating earnings from previous earnings.”[1] Think of a snowball rolling down a hill, it starts off small but as it gains momentum the snow builds off the existing snow and it starts to grow bigger and faster as the ball makes its rotations down the hill. Let’s look at a hypothetical example. Say you have $2000 that you put into your IRA each year for 20 years. This hypothetical IRA account is earning 12% interest each year.
[1] Chen, James. “Learn about Compounding.” Investopedia, Investopedia, 20 Apr. 2022, https://www.investopedia.com/terms/c/compounding.asp.
In absolute terms you would have contributed $40,000 of your own money into that account ($2,000 * 20 = $40,000) but, the value in your account would be far greater. In fact, you would have a balance over $160,000 in your account. If you continued with the same contributions for another 5 years (25 years total) your account value would be around $300,000, an additional 5 years (30 years total) you would be at around $540,000! Those are some significant numbers given the contribution amounts.
If you are interested in this topic and would like to sit down with one of our investment professionals here at SC Parker, we would be happy to answer any questions.
*Exceptions may apply. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice.
The reality is that there is no magical Investment account that is going to earn a consistent 12% each year with no risk. The market goes up and down and there are years when the market yields negative returns. But on average, the S & P 500 returns on average about 10% each year. So, what can you do to leverage the power of compounding interest? The best thing to do is to start early. Time and compounding go hand and hand. You may not see the results right away but over time it will add up. Looking at our earlier example, the difference of returns between year 25 and year 30 ($240,000) was far greater than between years 25 and 20 ($140,000). Starting early might not be possible for those of us who already missed “early” but starting when you can, will make a difference and the more you can contribute the more your account could earn. In 2022, the IRS allows individuals to contribute up to $6,000 annually to their IRA for those under age 50. People 50 and older can contribute up $7,000 annually to their IRA. Remember, IRAs are taxed deferred retirement accounts that you cannot take money out without penalty until age 59.5*.
[1] Andrew Withers | Madison Business Review. “Compound Interest: ‘the Eighth Wonder of the World’.” The Breeze, 16 Apr. 2021, https://www.breezejmu.org/business/compound-interest-the-eighth-wonder-of-the-world/article_11a24ebe-9e77-11eb-ba00-33aaec328747.html.
[1] Chen, James. “Learn about Compounding.” Investopedia, Investopedia, 20 Apr. 2022, https://www.investopedia.com/terms/c/compounding.asp.
