I’m often writing about the benefits of compound interest. In fact, Albert Einstein referred to it as “The Eighth Wonder of the World.” Why? Let’s see by looking at the difference a few percentage points can make as we compare a 4% compounded rate of return with an 8% compounded rate over a period of 50 years.
Now, simple math tells us that 8% is 2X (or 200% greater than) 4%. Using this logic without calculating compound interest, we may be tempted to think that an 8% return over 50 years would yield twice as much as a 4% return. (We might theoretically know compounding makes it grow exponentially, but sometimes we need to see the numbers on paper to really “get it.”) So, let’s take a look:
Looking at this chart, you can see that after 50 years of compounding, a one-time $100,000 investment at 8% becomes an incredible $5.4 million—732% GREATER than a 4% return of $736,000. What may seem like a small difference in returns the first few years can add up to a big difference after a longer period of compounding. It is hard to downplay the difference 4% makes!
Speaking of numbers, here’s a funny story about math (is there such a thing?).
A few years back when interest rates were very low for interest-bearing accounts, I had to move $600,000 from one bank account to another. The new banker told us we would collect a little bit of interest on the account. We knew it wouldn’t be much, but something is better than nothing, right? The standard interest rate was 0.02%, but with our bigger balance, we qualified for the gigantic rate of 0.06%. Based on 0.06% interest, the banker said we would receive $60 per year, per $100,000. Obviously, he made a mistake with the numbers—it should have been $600 in interest—but I thought he just didn’t know how to do math, and I was sad for him since he was the banker. Instead of embarrassing him by correcting his math in front of other customers, I later sent him an email explaining he had made a mistake: at 0.06% interest, we would be collecting $600 per year, per $100,000. I felt good about helping him out and saving him from future public embarrassment. That was the least I could do.
Our guy emailed me back and said he was sticking to his math. I looked at it again, and lo and behold, he was right! I was the one who couldn’t do the math. I just couldn’t get my brain to calculate that the interest paid on $600,000 could be that low, so I wasn’t accepting the answer. I kept multiplying $600,000 x .006 (0.6%) and coming up with $3,600 a year in interest instead of multiplying it by .0006 as the banker had correctly done. Earning $3,600 a year would have made it worth the hassle of moving the money around. Too bad I was one ZERO short in my calculation, or one ZERO long, depending on how you look at it.