How does compounding interest work?
There are a lot of strategies for investing, but one of the most basic is simple to start now. You can use time to your advantage by starting early and putting a concept called compounding to work for you.
How compounding interest works
Your money earns money over time, usually through interest or dividends. Then you earn money on your initial investment and the earnings. This is compounding. The more time your money has to grow through earnings, the more opportunity you have for compounding.
Here is a compounding interest example. Let’s look at two fictional investors – Sue and Bob – who earn an average 8% rate of return on their investments:
- Sue started saving and investing for retirement at age 30 and saved $2,000 a year for just 10 years. At the 8% rate of return, she ended up with $198,422 at age 65.
- Bob waited until he was 40 to start, but saved $2,000 a year for 25 years. Because he got a later start, he didn’t have as many years for his money to compound. He ended up with only $157,909 at age 65. That’s over $40,000 less than Sue.
The difference? Because Sue’s money had more time to compound, she ended up with a lot more at retirement, even though she put in $30,000 less than Bob.
The bottom line is that time is money, so make the most of it.
This example is only an illustration and isn’t intended to reflect the return of any actual investment. Investments don’t typically grow at an even rate of return and may even lose money. The effect of taxes and the costs of investing have not been reflected.