Albert Einstein reportedly called compound growth ‘the eighth wonder of the world’. And he’s not the only famous fan of this mathematical concept, with Warren Buffet saying his wealth came from “a combination of living in America, some lucky genes and compound interest.”
But what is compound growth? More importantly, how can it help you build wealth?
What is compound growth?
Compound growth is when an asset generates earnings, which are then reinvested to generate additional earnings over time.
For example, imagine you deposit $1,000 in a savings account that pays 5% interest annually. In year one, your balance would grow to $1,050 ($1,000 principal balance + $50 interest payment). If you leave the money untouched, the following year, you’ll earn 5% interest on $1,050 – which is $52.50, more than the year before.
That’s because you’re earning interest on interest – also known as compound growth.
While many people are familiar with the concept, they underestimate its power. After all, an extra $2.50 in additional annual earnings isn’t something you’d shout from the rooftops, right?
The thing is, leave this $1,000 in the hypothetical savings account for 25 years and you’ll keep earning 5% annual interest on an increasingly larger balance.
This is known as the snowball effect and means you’ll end up with a balance of $3,386.35 – all without doing anything.
The more time, the more growth
As you can see, time is the biggest key to compound growth. And the more time you have to save and invest – the more growth potential. That’s why it’s often good advice to start building your retirement nest egg as soon as possible.
While compound growth is commonly associated with interest payments, it works with any asset – for example, the capital growth of a property or a share portfolio. And the longer you hold the asset, the more growth potential – which explains the popular investment advice “it’s time in the market not timing the markets that matters”.
The rule of 72
You can use the rule of 72 to get an idea of how compound interest can grow your investment. Here’s how it works.
Take the number 72 and divide it by your investment’s projected annual return. The result is approximately the number of years it will take for your invested money to double.
For example, say you put $1,000 in an investment account that promised an 8% annual return. Then it would take approximately nine years (72 / 8 = 9) to grow to $2,000.
Leave the money in the account for another nine years (year 18), and your balance will double again to $4,000. In year 27, it will have grown to $8,000 and so on.
However, the formula isn’t completely accurate. If you need a more accurate estimate, use an online calculator.
How to use compound growth to your advantage
With compound interest, time is everything. So if you want to take advantage of its growing power you should:
- Save early and often – though it’s never too late to start putting money aside for a rainy day
- Reinvest any gains, rather than take them out
However, while compound growth is your friend when it comes to wealth-building – it works against you when borrowing money. Thanks to its snowball effect, paying compound interest can quickly make a debt spiral out of control.
To avoid this:
- Pay off debts quickly – especially credit cards with high interest rates
- Make extra payments on debt if possible
- Refinance your home loan onto a lower rate if circumstances allow
- Consider consolidating high-interest debt into your home loan