What is compounding? Simply, compounding is when the earnings on your money stay invested to earn even more money … and those earnings and principal stay invested to earn even more money. And so on.
Starting early can make a big difference
Consider the information below, and then answer this question: Who will have more money at age 65, Eloise or Joe?
Here is the investor profile for Eloise
- Starts investing $5,000 a year at age 25
- Earns 8% interest
- Stops investing after 10 years at age 35
- Total investment: $50,000
Here is the investor profile for Joe
- Starts investing $5,000 a year at age 35
- Earns 8% interest
- Stops investing after 30 years at age 65
- Total investment: $150,000
Chances are, you answered that Joe would have more money at age 65. But believe it or not, Eloise will have $787,100 at age 65, while Joe will have $611,730 at that age. That’s roughly $175,000 more for Eloise.1
How? The power of compounding. This example shows the time value of money – simply, how the earlier you begin to save, the more time you allow compounding to do its job.
So even though Eloise invested only one-third of the amount of Joe, beginning 10 years earlier made all the difference.
Giving your money more time to grow is an advantage
Consider another example. In this scenario, the individual – let’s call her Alice – invests $250 a month. In 30 years, at 6% interest, Alice will have a little over $250,000, having invested a total of $90,000.
But what if Alice starts 10 years sooner? She invests $250 a month for 40 years, which is an additional $30,000. That’s only 25% more - yet her money nearly doubles, growing to more than $497,000. That is the power of compounding. Add five more years? She’ll have just about $689,000, having invested an additional $15,000, and let compounding do its work.
Alice – Invests for 30 years
- $250/month investment
- Earns 6% interest
- Total investment: $90,000
- Account balance after 30 years = $250,000
Alice – Invests for 40 years
- $250/month investment
- Earns 6% interest
- Total investment: $120,000
- Account balance after 40 years = $497,000
Alice – Invests for 45 years
- $250/month investment
- Earns 6% interest
- Total investment: $135,000
- Account balance after 45 years = $689,000
Have you heard of the Rule of 72?
When it comes to understanding the power of compounding, one of the best - and easy-to-use - tools is the Rule of 72.2 It’s a way to estimate the time it will take for an investment to double when it earns a fixed annual return rate.
All you need to do is divide 72 by the annual rate of return. The answer is the number of years it will take for your money to double.
For example, let's say you have an investment with an annual interest rate of 6%. By applying the Rule of 72, you divide 72 by 6, which equals 12. This means that it would take approximately 12 years for your investment to double in value at a 6% interest rate.
It's important to note that the Rule of 72 provides a rough estimate and assumes compound interest is the only factor at play, not taking into account other variables and market conditions that can affect investment growth.
This chart explains how the Rule of 72 works. The Rule of 72 states that dividing 72 by your interest rate percent will show how long it will take for your money to double. The examples in the chart show how a 12% interest rate will take 6 years to double; 8% will take 9 years, 6% will take 12 years, 4% will take 18 years, and 2% will take 36 years.
What’s the lesson for you?
As you think about building wealth for the future, time is one of your greatest advantages. If you haven’t started saving for the future yet – or have put off increasing how much you save – start right away. None of us can go back in time but recognizing the time value of money means today could be the very best day to get started.
And consider this – with people living longer and spending potentially 30+ years in retirement, even if you didn’t begin at age 25, you can still take advantage of the time value of money. The decisions you make today can have a positive effect on later retirement years as well – age 65 is not the only goal. So, consider investing as soon as possible and staying invested over the long haul to take full advantage of the power of compounding.
1 Federal Reserve Bank of St. Louis
2 The Rule of 72 does not guarantee investment results or function as a predictor of how an investment will perform. It is simply an approximation of the impact a targeted rate of return would have. Investments are subject to fluctuating returns and there can never be a guarantee that any investment would double in value. The Rule of 72 is shown for illustrative purposes and does not represent the past or future performance of any specific product or investment. Distributions from the tax-deferred account will be taxable when withdrawn.
Investing involves risk, including the possible loss of principal.
1 Federal Reserve Bank of St. Louis
2 The Rule of 72 does not guarantee investment results or function as a predictor of how an investment will perform. It is simply an approximation of the impact a targeted rate of return would have. Investments are subject to fluctuating returns and there can never be a guarantee that any investment would double in value. The Rule of 72 is shown for illustrative purposes and does not represent the past or future performance of any specific product or investment. Distributions from the tax-deferred account will be taxable when withdrawn.
Investing involves risk, including the possible loss of principal.