One of the easiest tools at investors' disposal for building wealth isn't how good they are at stock picking, their knack for flipping houses, or jumping on the latest cryptocurrency trend. Instead, it's slowly and methodically investing their money.
Compound interest has helped investors substantially increase their retirement account over time as their original investment earns money and then continues to earn money on top of the new balance, year after year.
If you're new to the idea of how compounding interest works, here's a quick overview and how it can help you retire as a millionaire, even while earning a modest income.
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How compound interest works
The basic idea of compound interest is that you continually earn money on your earnings, not just on the original amount you invested. For example, let's say you invest $1,000 and earn 10% interest on that investment. At the end of the year, you'd have $1,100.
That's a good return, to be sure. So now you have $1,100 starting your second year of investing, instead of the $1,000 you started with. If you earned 10% again in the second year you'd have $1,210 at the end of the second year.
This may not seem like a significant increase initially, but as your earnings continue to increase, so does the magnitude of their earning potential. Take a look at these results, based on an initial $10,000 invested, no additional out-of-pocket contributions, and compound interest going to work.
| Starting amount | Years Invested | Annual Return | Ending Amount |
|---|---|---|---|
| $10,000 | 5 | 10% | $16,105 |
| $10,000 | 10 | 10% | $25,937 |
| $10,000 | 15 | 10% | $41,772 |
| $10,000 | 20 | 10% | $67,275 |
| $10,000 | 25 | 10% | $108,347 |
Calculations by author via investor.gov.
As you can see, your initial investment of $10,000 starts to see significant benefits from compounding interest very quickly.
There are two things to note here. The first is that we're assuming a 10% annual return because that's been the historic average for the S&P 500 over the past 60 years. Some years your investments will earn more, and sometimes they'll earn less; that's normal.
Additionally, these totals don't factor in any additional contributions you make to your retirement account. Most people don't just put a lump sum of money into their retirement account and let it sit there for years. Instead, they make regular contributions to their investment account, like a low-cost Vanguard S&P 500 exchange-traded fund (ETF). Below, we'll factor in these regular contributions to see just how large a nest egg can grow from a modest beginning.
Here's how compound interest can help you retire a millionaire
Everyone's idea of what a modest income is can vary, but let's use the median household income reported by the 2023 U.S. Census Bureau, which is $80,000.
Most financial planners recommend saving 15% of your income for retirement each year. If we assume $80,000 in household income and don't make any changes to that salary over time, then the annual savings amount is $12,000, or $1,000 per month.
Assuming you earn the average annual return of 10% (again, this will vary over time), here's how much your investments will earn with compounding interest over time:
| Starting Amount | Monthly Contribution | Time Invested | Annual Return | Ending Amount |
|---|---|---|---|---|
| $1,000 | $1,000 | 25 years | 10% | $1.19 million |
| $1,000 | $500 | 30 years | 10% | $1 million |
Calculations by author via investor.gov.
As you can see, time works very much in your favor for letting compound interest work its magic. The more time you have, the less you have to invest to reach your goal of $1 million. Conversely, if you have less time to invest, then you can catch up by investing more into your retirement account each month.
It's also worth mentioning that reaching $1 million doesn't have to be the retirement goal for everyone. Many people have far less and have perfectly good retirements. Just keep in mind that some retirement experts recommend retirees have 55% to 80% of their annual preretirement income to maintain their current lifestyle.
