Like nearly everyone else on the internet, I'm a fan of xkcd, the nerdy webcomic from Randall Munroe. My wife, who's a chemist, loves xkcd's science episodes (such as this and this), while I like everything else (especially this and this). And let's not forget the map of online communities!
Many of you e-mailed to tell me that yesterday's xkcd tackled a subject near and dear to our hearts: personal finance. Specifically, Munroe poked a hole in the myth of the magic of compound interest. Sort of. Here's the comic:
I've received several messages from readers over the past few months questioning the efficacy of compounding. Here's the thing, though: Compounding is awesome. And it works. But it's not a magic bullet. It's one tool in your financial toolbox, a toolbox that includes Roth IRAs and budgeting and conscious spending. So let's be clear: A high-yield savings account won't make you rich. In fact, no single financial tool is going to do that. But used together, you can construct the life of your dreams.
I ran several scenarios through Money Chimp's compound interest calculator, and here's what I got.
- Using the example from the xkcd strip, if you made a single $1000 investment at a 2% rate of return, in ten years you'd have $1218.99.
- Perhaps obviously, if you started with $10,000 instead, you'd have $12,189.94 after ten years.
- Using a more life-like example: If you maxed out your Roth IRA every year with a $5,000 contribution to an investment returning 2%, after ten years you would have contributed $50,000 and your balance would be $53,357.28.
- If you followed this investment program for thirty years, your total contributions would be $150,000. Your final balance would be $210,954.01.
- Getting more life-like yet, what if you earned an average of 10%, which is the long-term average return for the U.S. stock market? If you invested $5,000 a year for thirty years and were able to earn an an annual return of 10%, your $150,000 would be worth $986,964.14.
Important Note: While the U.S. stock market has returned an average of 10% per year over the long term, shorter investment periods are much more volatile. And, in fact, average is not normal. That is, some years — as in 2008 — the market (the , in this case) returns -37.00%. Other years — as in 2009 — the market returns +26.46%. The market almost never returns just 10% in a year.
As you can see, you shouldn't ignore the power of compounding. Compound returns can be (and often are) instrumental in boosting wealth.
Still, Munroe makes a very important point: The single greatest factor in determining your retirement wealth isn't your investment returns — it's how much you contribute. In other words, you can't just throw a few thousand dollars into a retirement account and then hope everything's going to work out. You have to keep at it. You have to continue contributing. The more you save, the more compounding will work in your favor.
It's because of this that I'm always harping on the need to increase your income. I'm dead serious when I write that nothing will supercharge your finances like finding a way to make more money. And you know what? For the most part, this is something you are completely in control of. When I say that nobody cares more about your money than you do, this is one of the things I mean. If you truly want to have more money — so that you can pay off your debt, send your kids to college, travel the world, and so on — then the single best thing you can do is boost your income.
But don't bury your increased income under a rock. Don't go spend it just because an internet comic strip tells you that compounding isn't worthwhile. Compounding matters. Make as much money as you can, and invest it wisely so that, in time, the magic of compounding can help to make you rich.
Footnote: As some GRS readers noticed, an episode of xkcd from last week also addressed personal finance. That one's a little more controversial, though; if I'm going to tackle it — and I might since I agree with it — I need to time to refine my thoughts.
J.D. Roth
In 2006, J.D. founded Get Rich Slowly to document his quest to get out of debt. Over time, he learned how to save and how to invest. Today, he's managed to reach early retirement! He wants to help you master your money — and your life. No scams. No gimmicks. Just smart money advice to help you reach your goals.
View all posts by J.D. Roth
FAQs
Which Is Better, Simple or Compound Interest? It depends on whether you're saving or borrowing. Compound interest is better for you if you're saving money in a bank account or being repaid for a loan. If you're borrowing money, you'll pay less over time with simple interest.
Is it better to compound more often or earn a higher interest rate? ›
The more often interest is compounded, the better. When comparing two accounts with the same interest rate, the one with more frequent compounding may have a higher yield, meaning it can pay more interest on the same account balance.
Which one simple or compound interest would be better for you to make money faster? ›
When it comes to investing, compound interest is better since it allows funds to grow at a faster rate than they would in an account with a simple interest rate. Compound interest comes into play when you're calculating the annual percentage yield.
Does more compounding mean more money? ›
The more frequently the interest is compounded, the higher the yield, or the rate of return on your investment. For example, if you had $5,000 in an account that paid 5% annually in simple interest for five years, you'd earn $250 a year, for a total of $1,250 in interest.
Why do people prefer compound interest? ›
Why is compound interest important? Compound interest causes your wealth to grow faster. It makes a sum of money grow at a faster rate than simple interest because you will earn returns on the money you invest, as well as on returns at the end of every compounding period.
Why is compound interest more beneficial? ›
This means, not only will you earn money on the principal amount in your account, but you will also earn interest on the accrued interest you've already earned. The idea of compound interest (as compared to simple interest) is fundamental to investing because it can ultimately lead to a greater return in your account.
What are the disadvantages of compound interest? ›
Disadvantages Explained
Works against consumers making minimum payments on high-interest loans or credit card debts: If you only pay the minimum, your balance could continue growing exponentially as a result of compounding interest.
How much is $1000 worth at the end of 2 years if the interest rate of 6% is compounded daily? ›
Hence, if a two-year savings account containing $1,000 pays a 6% interest rate compounded daily, it will grow to $1,127.49 at the end of two years.
What is the rule of thumb for compound interest? ›
The Rule of 72 is a calculation that estimates the number of years it takes to double your money at a specified rate of return. If, for example, your account earns 4 percent, divide 72 by 4 to get the number of years it will take for your money to double.
Can compound interest make you rich or poor? ›
It's one of the most powerful forces in finance, and it can work for you or against you. If you're investing in assets that appreciate over time, compounding can help you build wealth rapidly. But if you're in debt, compounding can make it harder and harder to get out.
To take advantage of the magic of compound interest, here are some of the best investments:
- Certificates of deposit (CDs) ...
- High-yield savings accounts. ...
- Bonds and bond funds. ...
- Money market accounts. ...
- Dividend stocks. ...
- Real estate investment trusts (REITs)
Top 7 Compound Interest Investments
- CDs. Considered a safe investment, banks issue certificates of deposit and generally offer higher interest than savings, typically FDIC-insured up to $250,000. ...
- High Yield Savings Accounts. ...
- Rental Homes. ...
- Bonds. ...
- Stocks. ...
- Treasury Securities. ...
- REITs.
Increased Compounding Periods
Assume a one-year time period. The more compounding periods throughout this one year, the higher the future value of the investment, so naturally, two compounding periods per year are better than one, and four compounding periods per year are better than two.
What is the best explanation of compound interest? ›
Compound interest is the interest calculated on the principal and the interest accumulated over the previous period. It is different from simple interest, where interest is not added to the principal while calculating the interest during the next period. In Mathematics, compound interest is usually denoted by C.I.
Is compound interest always greater than simple interest? ›
Compound interest is always lesser than simple interest when calculated on the same principal, time period and rate of interest. Q. Compound interest is greater than the simple interest for the same time(2 years) and at the same rate of interest.
What is the best way to explain compound interest? ›
Compound interest is when you earn interest on the money you've saved and on the interest you earn along the way. Here's an example to help explain compound interest. Increasing the compounding frequency, finding a higher interest rate, and adding to your principal amount are ways to help your savings grow even faster.
