How does compound interest work? It almost seems like magic! Well, it turns out that it's not magic at all; it's just math. Join Rev. Drew Gysi and Financial Advisor Tim Russell, CFP® as they discuss the impacts of compound interest when investing.
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I always love a good magic trick. I loved watching David Copperfield as a kid. But magic tricks require sleight of hand, visual illusions, and deception. In short, they are not real.
Now, I’m no magician. I’m not clever enough to pull off the sleight of hand that "wows" the audience. The closest thing to magic in my world is the power of compound interest in investing. Compound Interest is not magic, it’s math. Quality investments do not involve sleight of hand or deception. Yet, when given enough time, these quality investments can produce amazing results due to the power of compound interest.
Disclaimer - There are just a few things to remember before we begin. I know we shared them moments ago in the intro but given the nature of our discussion, there are a few things that you are going to want to keep in mind.
Simple interest is when you earn interest on your original amount at a fixed rate but your interest does not grow from year to year. For example, if you put $1,000 in an instrument that earns 8% a year (simple interest), you would receive $80 each year for as long as you hold that instrument. The interest received does not change over time.
Compound interest is simply when you earn interest on top of your interest. If you invest $1,000 in a mutual fund and that fund grows by 8% a year, you will have $1,080 after one year. If you leave that in for another year, the $80 of interest earned in the prior year also grows at the same rate of 8%. After the second year, your $1,000 original investment has grown to $1,166.40. If we continue to receive the same rate of growth for a total of 10 years, your $1,000 would have grown to $2,158.92.
The Difference Between APR and APY
You may have noticed at the bank when interest rates are provided for either a deposit account, like savings or CD accounts, or loans, like CC, HE Loans, or Car Loans, they show an APR (Annual Percentage Rate) and APY (Annual percentage Yield). What is the difference? Which one should I pay attention to?
APR - is the annual rate of interest for an account or loan. This is how much you would earn or pay in a year at simple interest.
APY - is the annual rate of interest for an account or loan while also taking into effect the number of periods (or months) in a year that the interest compounds.
Example: Loan - If you have a CC that charges 1% a month interest it would promote it’s 12% a year (APR). If you were charged for only one month of interest it would be the equivalent of 12% a year. However, if you held that same balance for a full year (12 periods), you would not simply owe 12% interest because there would also be interest on your interest (compounding). The APY reflects a more realistic cost of the loan over a full year. In this illustration, the APY would be 12.68%.
Example: Bank CD - If you have a CD that earns 0.50% a year interest it would promote it’s APY. This is because the bank knows that you would want to keep the CD invested for the full term and would therefore earn interest on your interest. That, and it makes them look better because the APY of 0.5% looks better than their equivalent APR of 0.49876%.
Critical considerations for compounding interest
The Rule of 72
We are really bad at mental math. This is especially true when it comes to anticipating compound interest. There is a general rule of thumb that can help you better estimate the long-term impacts of compound growth. It’s called the rule of 72. In a nutshell, if you take the number 72 divided by the rate of growth, you will see how many years it will take for the account to double. Keep in mind that this is not exact but pretty close. It does not take into effect the sequence of returns which can have a substantial impact on the time it takes to double.
Take a look at the chart below to see the impact of interest rate on the number of years it would take an investment to double:
One of my favorite ways to use the rule of 72 is to help clients know if they are “on track” for retirement. Let’s say that I’m meeting with a married couple age 35. They have $100k in retirement savings. The rule of 72 means that if they earn 7.2% each year, their accounts would double in 10 years.
Keep in mind that this does not include annual contributions which we know they will make. This gives me a “worst case scenario” for gaging their progress.
The other thing to keep in mind is how much monthly income they will need in retirement. Let’s assume for a moment that they anticipate $3,000/mo in SSA (yes, we’ll assume that SSA still exists). Let’s say that they think they are going to need $8,000/mo in retirement. That means that they will need to generate $5,000/mo in additional income. This could potentially be generated from a $1,250,000 portfolio if they take a 4.6% annual withdrawal. For easy $250k of invested assets, you can generate $1,000/mo of income if you take a 4.6% withdrawal. The higher the withdrawal rate, the greater the likelihood of outliving your income. The lower the rate of withdrawal, the greater likelihood you will not run out of money.
In this situation, you might think that this couple can sit back and relax because they are on track. The reality is that these estimates are not guaranteed and they do not take into account inflation. I would rather be more aggressive with the savings plan to account for inflation and unexpected poor performance.
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The topics discussed in this podcast are for general information only and are not intended to provide specific investment advice or recommendations. Investing and investment strategies involve risk including the potential loss of principal. Past performance is not a guarantee of future results.
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