What Does Warren Buffett Know That You Don't About Compound Interest?

Rudro Chakrabarti
What Does Warren Buffett Know That You Don't About Compound Interest?

"The most powerful force in the universe."

"The greatest invention in human history."

Many people claim Albert Einstein used those phrases to describe compound interest.

Whether he did or not, one thing rings true: When considering a wealth-building strategy, compound interest is a very powerful savings tool. And it's pretty cool. Read on to learn all about compounding, and how you can best reap the rewards.

What is compound interest?

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Watch your money grow with compound interest.

Compound interest builds your money at an accelerated rate. It's interest on top of interest: Your deposits pile up interest, and the interest piles up interest, too.

That can mean incredible growth over time.

Let's say you deposit $20,000 into a high-yield savings account paying 3.25% interest that's compounded annually.

  • In the first year, you'd earn $650 interest — and have a total of $20,650.
  • In the second year, you'd earn $671 interest, on the principal and the previous interest — and have a total of $21,321.
  • In the third year, you'd earn $693 interest, on the principal and the previous interest — and have a total of $22,014.
  • In the fourth year, you'd earn $715 interest, on the principal and the previous interest — and have a total of $22,730.
  • In the fifth year, you'd earn $739 interest, on the principal and the previous interest — and have a total of $23,468.

Compound interest is different from simple interest, which is earned on only the intial principal amount year by year.

Here's what that $20,000 investment would look like with simple interest, paid out over the same period:

  • In the first year, you'd earn $650 interest — and have a total of $20,650.
  • In the second year, you'd earn another $650 interest, on the principal only — and have a total of $21,300.
  • In the third year, you'd earn another $650 interest, on the principal only — and have a total of $21,950.
  • In the fourth year, you'd earn another $650 interest, on the principal only — and have a total of $22,600.
  • In the fifth year, you'd earn another $650 interest, on the principal only — and have a total of $23,250.

The difference between $23,468, with compound interest, and $23,250, with simple interest, may not seem like much. But the comparison is a lot more impressive over a longer term.

After 23 years with compound interest, you will more than double your initial investment to $41,735, while with simple interest you'll be looking at just $34,950.

And, after 50 years, interest that's compounded will turn your $20,000 into nearly $100,000 ($98,977, to be precise), versus $52,500 with simple interest.

Just imagine the power of compounding interest, if you were making regular contributions to that savings account.

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Accounts with compound interest

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Choose the right savings account to help compound your growth.

Here's some good news: You'll find compound interest is far more common than simple interest when you're looking for a place to stash your savings. There are a couple types of savings vehicles you can open to make compound interest work for you.

Certificates of deposit (CDs) are probably one of the safest places to keep your money and watch it grow. CDs typically offer the highest interest rates, but they lock your funds up for a fixed term.

These terms vary from anywhere from six months to five years or more, and there are penalties for withdrawing early. Once the term has ended, you have the option to renew and keep your money growing in the CD, or take it out.

The locked nature of CDs can be restrictive, meaning you shouldn't use a CD as your emergency savings account, because you won't have quick access to the money if something comes up. (And something always comes up!)

You also can't deposit more funds into a CD until it matures and is up for renewal.

High-yield savings accounts will give you flexibility to withdraw and deposit funds whenever you wish, and — although the interest rates won't be as high as the rates on CDs — the accounts provide solid returns over time.

To keep your savings more agile, a high-yield savings account might work best.

Note that these accounts typically require a minimum deposit. As you shop for a high-yield savings account, compare terms and choose an account that will work best for you.

Be like Buffett

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Please, oh please make me like Warren Buffett.

When you talk about successful investing, name-dropping the Oracle of Omaha is inevitable. Warren Buffett is a shining example of how you can grow your money through compounding.

"My wealth has come from a combination of living in America, some lucky genes, and compound interest," he once wrote.

If you look at examples of Buffett's portfolios, you'll notice he's mostly invested in stocks that pay dividends — which offer another form of compounding.

One of the best things you can do, if you're OK with a little risk, is invest in a combination of stocks, mutual funds, and ETFs that pay dividends. Make sure you do your research.

When dividends are reinvested, they generate more dividends, and the compounding dance continues.

If investing on your own intimidates you, automated investment services, such as Wealthsimple and Blooom, do the heavy lifting for you and cut the cost of investment fees.

Whether you're saving in the short term, or investing for the long haul, compound interest is your best friend. So give it a hug, and let it work for you.

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