Dollars & Sense
Growth Factors
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn’t ... pays it.”
When it comes to investing, or borrowing money for that matter, two factors make all the difference: the power of compounding and time.
Compounding is the process of earning interest on interest or dividends on dividends, over time. At first, your money grows relatively slowly, then with increasing speed as compounding takes effect. The reverse happens with debt when payments do not equal the amount of interest accruing on the account.
Suppose you invested $ 100,000 for 20 years at 6 percent annually, with earnings paid yearly. In one scenario, you withdraw your earnings each year. In a second, you reinvest those earnings at 6 percent. Assuming no taxes are paid, in 20 years, the account that is allowed to compound will be worth $ 320,713— a $ 220,713 increase in value. If you had simply withdrawn your earnings each
— ALBERT EINSTEIN
year, you would have $ 220,000, an increase of $ 120,000 over your original investment. Compounding nearly doubled your return in this example.
If earnings are paid quarterly rather than annually, compounding goes to work even quicker. A $ 100,000 account earning 6 percent compounded quarterly would be worth $ 329,066 at the end of 20 years, an increase of more than $ 8,000. Increase the rate of return, or pay earnings monthly, and growth is even quicker.
The longer compounding has to work its math, the more substantial the increase in value can become.
Beware the Dark Side
Credit card debt, where only the minimum payment is made each month, is a perfect example of the dark side of compounding. When the minimum payment does not cover the interest incurred over the month, that interest is added to the outstanding balance and interest accrues on interest. The result, as many individuals have discovered, can be devastating.
Losses are another way to look at the dark side of compounding. If your account loses 25 percent, it doesn’t take 25 percent to recover, it takes 33 percent. The reason is that you are starting from a smaller balance. If a $ 100,000 account falls $ 25,000, the remaining $ 75,000 has to earn 33 percent to return to $ 100,000, which is why minimizing losses can have an outsized impact on long- term values.
The Tax Bite
To enhance the power of compounding on your investments, you want to minimize the impact of taxes. After all, every dollar you pay in taxes reduces the amount you have to compound. For example, if you had to pay 15 percent capital gains taxes on your earnings each year, at 6 percent your account would grow to just $ 270,429 in 20 years. That’s why it’s important to invest as much as you can in tax- deferred retirement accounts, or better yet, a Roth IRA, where earnings accumulate tax free.
Understanding the value of time and compounding is an important step toward accumulating wealth. The more you allow earnings to compound, and the longer compounding occurs, the greater the end value.
The compounding examples cited are hypothetical and used for illustrative purposes only. Investment results fluctuate and past performance is not indicative of future results. The possibility of loss exists along with the potential for profit.