If you were lucky enough to have an economics class in high school, you may have heard of the term compound interest. Compound interest is the interest accumulated on the combined principal and interest, over time. In other words, you earn interest on your total balance including both the principal and the interest you have already earned. Earning interest on your interest is compounded interest. It’s how the rich get richer.
As an Industrial & Manufacturing Engineer, I had to take an engineering economics course that included internal rate of return, trade studies, salvage value calculations, and compound interest among other financial concepts. Engineers are often required to purchase or source equipment, evaluate investments and payback periods, and manage multi-million dollar projects.
The formula for compound interest is as follows:
=P[1+(r/n)]^nt
where P = payment, r = interest rate, n = number of periods the interest is compounded within a time, and t is the period length in years. If compounded monthly, n = 12. If compounded quarterly, n = 4. If compounded annually, n = 1.
Practical Examples of Compound Interest
- Stock Market – Let’s say you deposit $500 monthly into the stock market earning you an annual return of 7.00% through capital gains and dividend reinvestment. After 10 years, you would have around $84,000. That means you would have made about $24,000 on your $60,000 investment.
- Savings Account – If you deposit $1,000 into a savings account that earns you 1%, you will have $1,010 at the end of the first year. By the end of your second year, you would have $1020.10. The $0.10 came from earning 1% on the $10 of interest you earned in the prior year. Assuming your 1% annual interest never changes, your $1,000 savings will grow to $36,000 after 30 years.
Investing VS Paying Off Your Mortgage Early
Instead of investing $500/month in the stock market, let’s say you put an extra $500/month towards your 3.9%, 30 year $250,000 mortgage starting at period 0 and ending at period 120 (10 years), you would save just over $82,000 of interest over the life of the loan and shave about 13 years off. This amount is similar to investing the same amount of money in the same time period, however, investing your money will grow faster from here on out. With an amortized loan like your mortgage, you have already saved a huge chunk of interest by paying an extra $500 within the first 10 years of the loan term. If you continue paying $500 per month extra, your interest savings will slow down over time. The opposite happens with investing in the stock market. Instead, your investment grows faster. Interested in a copy of my loan amortization table in Excel? Click here.
How long would it take to earn $1 Million?
If you assume 7% annual return on your investments, this is what it would take to reach $1,000,000.
- $300 per month would take approximately 43 years, the average working life of someone who works right out of college and retires at 65.
- $500 per month would take approximately 36 years.
- $1000 per month would take approximately 27 years.
Other factors to consider are your assets. How much is your house worth? Do you own gold? Did the $100 crypto investment that you forgot about grow to $1 million? How much will you get in social security? Do you have a pension or other retirement account?
