The Magic of Compounding Interest

Can Compounding Interest Work In Your Favor?

Yes, compounding interest can work in your favor. Compounding interest is easiest to explain by using the example of a savings account. However, you can evaluate your returns on other investments by using this simple formula. 

Say you have $500 in a savings account that pays you five percent interest annually. If you save that $500 for three years you will have $578.81 at the end of year three. 

P = $500 

I = .05 

N = 3 

500(1+.05)3 = 578.81 

Not bad, you earned almost $80 with little effort on your behalf.

Unfortunately, most savings accounts do not pay anywhere near five percent anymore (that was years ago!). The typical interest rate on a savings account is currently around .01%. So, $500 in a savings account for one year at .01% earns only five cents. Luckily, there are other places out there to put some money. 

What if you invested $500 in a diversified stock fund that grows an at a 5% average annual rate for 20 years?  Your $500 investment in that fund could turn out to be $2,330.48! Pretty amazing – your money has quadrupled in that time!  A note here though that stocks, mutual funds and ETFs do not have consistent, steady returns, are riskier than savings accounts, and can lose money.  However, our formula indicates that the right investments have the potential to outperform a savings account. 

It is best to talk to an investment advisor if you want to start investing so you can understand the risks involved and the appropriateness of any particular investment for your situation. 

Contributed By: John Richter, CPA | DWD CPAs & Advisors