The Power of Compound Interest. . .Even Math Geeks will be Amazed

Recently, my friend Jay Monee over at Budgets are Sexy wrote an article about the power of compound interest. (You may remember Jay from my interview with him on how he makes money online.)

In his article, he asked a great question: “If you start with a penny on day one, and double it every day until the end of the month, how much would you have?”

Take a second to think about the answer to his question.

On day one we start with a penny. On day two it doubles to two pennies, then four, eight, 16, 32 and then 64 on day seven. So at the end of a week, we’d still have less than a dollar - 64 cents, to be exact. That’s not very exciting.

But what do you think you'd have at the end of the month?

As you know I’m a big fan of Excel. So we can also use an Excel spreadsheet to figure this out quickly.

Open up Excel (or a Google spreadsheet), and find the function box. Type in "=fv" for future value, followed by an open parenthesis. In the parenthesis we'll input four values:

• Interest rate: 1 - Usually we put in something like .08 for 8%, but since we're doubling our money, the interest rate is actually 100%.
• Number of periods: 30 - Since we start on day 1 and double our money every day until day 31, we’re going to double it 30 times.
• Payments: 0 - We aren’t making payments because we aren’t adding any capital.
• Present value: .01 - We start with just a penny, so the present value is .01.

Type all that into the function box, hit enter, and what do you get?

That's right: over $10 million. Amazing, but true.

Compounding interest is something we talk a lot about here, but this calculation really brings the concept to life.

Now back down to earth. We won't be doubling our money every day or even every year. But the power of compound interest is still amazing. To harness that power, you need three things: time, growth, and capital.

Time is the most important factor. How do you harness time? You start investing now.

If you start at 20, you've got more time than you do if you start at 50. But for those who are 50 or 60 and believe they're out of time, you're not. You're not out of time until you die. So if you're saying, "I'm 50. How much time do I really have?" Well, you've got more now than you'll have when you're 55.

The second thing you need is growth. You want as high a rate of return as possible without assuming excessive risk. We’ve talked a lot about asset allocation in our podcasts and blog posts. But, in general, know that stocks are better than bonds when it comes to long-term returns. Bonds have their place in a portfolio, but your investments in stocks or stock mutual funds are where the growth will occur.

Of course, you’re never going to double your pennies, as in Jay Monee’s example. But there’s a huge difference between earning 6% a year and 7% a year, or 7% and 8%. That’s why investing costs matter so much. What seems like a small difference in the rate of return makes a huge impact over time, given the power of compound interest.

The third thing you need is capital. You need money to invest. That’s why we talk about spending less than you make and investing the difference. You can invest a relatively small amount of capital, and - if given time and a decent return - generate a lot of money. But you need some capital to experience the power of compounding.

So that’s how you harness the power of compound interest. You may not get $10 million from a single penny, but given enough time, a good growth rate, and some capital, you can build a comfortable nest egg. It’s probably the most powerful money tool we’ll ever talk about.