What is just as awe-inspiring as Stonehenge? For the personal budgeter, it's compounding interest.
Don’t take our word for it. Albert Einstein (he knows a thing or two) said, “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
Wise words from a wise man.
What is Compound Interest?
Compound interest, in simple terms, is interest that builds upon itself. Interest alone can be powerful but when it has time to compound, it produces truly amazing results. Let’s assume I invest $1,000 and receive 10% interest that compounds every year.
After year 1: $1,000 * 1.10 = $1,100
After year 2: $1,100 * 1.10 = $1,210
After year 3: $1,210 * 1.10 = $1,331
Notice each year the amount of interest I receive increases because it is compounding on the principle (the amount I put in originally) and the prior interest earned. After year 30, I would have $17,449.40 and after year 60 I would have $304,481.64. A one-time investment of $1,000 can turn into a small fortune given the appropriate time.
This begs the question: How do we make the most out of compounding interest?
Max out your retirement accounts as early as possible.
Time is what allows the eighth wonder of the world to work its magic. The best way to build wealth is to put your money in retirement accounts which have added tax benefits. These accounts will offer tax deferred/tax free growth, maximizing the amount that will compound in your investments. A person who maxes out their 401(k) contribution every year ($23,500 in 2025) will have $2,220,838 in 30 years and $4,692,422 in 40 years (assuming an average 7% rate of return). That’s a nice chunk of change!
Move your emergency fund into a high yield savings account.
If you were like me, you earned 0.01% on your savings account year after year and didn’t realize you could easily be earning 2 to 5% on your cash! I was tired of the $0.06 of interest earned on our emergency fund; now, I’m earning 4% every year without taking any added risk or even lifting a finger. There are a number of solid savings accounts that will provide you a much better interest rate. Click here for a few great options.
Pay off your debt ASAP!
This is exactly what Einstein was talking about when he said, “he who doesn’t [understand compounding interest]... pays it!”. Those credit cards you are paying 18% interest on compound. Pay them off or suffer the consequences. If you think it’s okay to scrape by on the minimum monthly payment, think again. When you have debt, you need a sense of urgency to pay it off fast. The sooner you’re debt free the sooner you can build wealth. Paying compounding interest can be the single greatest obstacle between you and financial freedom.
When you've got compounding interest working in your favor, it'll drop your jaw more than your first look at the Grand Canyon.