Broker Check

The Truth About Compound Interest

January 18, 2023

Now that savings rates are out of the tank for the time being, we will most likely hear and read a lot more in the news about the "miracle of compound interest." But is compound interest all it's cracked up to be?

What is compound interest?

Investopedia defines compound interest as the interest on savings calculated on both the initial principal and the accumulated interest from previous periods. "Interest on interest," or the power of compound interest, is believed to have originated in 17th-century Italy. It will make a sum grow faster than simple interest, which is calculated only on the principal amount.

Why do some refer to compound interest as a "miracle" strategy?

A recent article in Forbes´╗┐ outlines the following example, one which may seem too good to be true, but most national financial talk show pundits will still advocate.

With compound interest, you're not just earning interest on your principal balance. Even your interest earns interest. Compound interest is when you add the earned interest back into your principal balance, which then earns you even more interest, compounding your returns.

Let's say you have $1,000 in a savings account that earns 5% in annual interest. In year one, you'd earn $50, giving you a new balance of $1,050. In year two, you would earn 5% on the larger balance of $1,050, which is $52.50—giving you a new balance of $1,102.50 at the end of year two.

Thanks to the magic of compound interest, the growth of your savings account balance would accelerate over time as you earn interest on increasingly larger balances. If you left $1,000 in this hypothetical savings account for 30 years, kept earning a 5% annual interest rate the whole time, and never added another penny to the account, you'd end up with a balance of $4,321.94.

What many forget is that there are costs you may incur.

What are the costs associated with using compound interest as a strategy?

While growth on any account designed for accumulation is what we all desire, we should also be aware of the cost incurred while the "miracle" is taking place.

The main cost would be the taxes paid every year on 1099 received from the gain of the compounding.

Think of it this way: Are you making 5% on your money, or are you earning less due to the tax you'll have to pay on the growth each year?

If you're young, just starting out in life, or can save money and are not in a high tax bracket, then compounding may not be that expensive of a strategy.

Here's an example of someone in a 25% tax bracket: $100,000 growing at a fixed compounded rate of 5% sounds fantastic, doesn't it? The cost of compounding just for that one year is $1,250, and it has to be paid either from your income or from some other asset you own.

But there's more to consider:

  • In 5 years, with everything staying the same, the cost in tax alone is $6,907.00 - that is just in taxes paid.
  • 10 years the cost is $15,722, and in 20 years, it is $41,332.

By the time this 40-year-old, starting out in life, gets into the golden years, the cost at age 65, while still compounding, is $63,892 and growing. Factor in a modest lost opportunity cost of 4% on the tax paid over those 25 years, and the "miracle of compounding" cost you $97,900.

In summary, you've locked up $100,000 to get it to grow at the cost of almost $100,000 to get $355,567. Who experienced a "miracle"? The institutions that kept your money to use money multiple times or you?

We want to be clear; compound interest may be the right strategy for some, but not for everyone. If you have questions about the use of compound interest or your retirement strategy in general, please contact us.