One of the things I never get tired of writing about is compound interest, as it is arguably one of the most fascinating and exciting concepts in the financial world. If you don't understand how compound interest can affect you and your investments, you are at a huge disadvantage. In his 1964 Buffett Partnership letter, Warren Buffett (Trades, Portfolio) discussed this topic:
"It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens. If over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled."
The eighth wonder
Once described as the eighth wonder of the world by Albert Einstein, compound interest is the process of your money making money. Over the long term, the power of compound interest can really add up, so much so that just a few percentage points of returns every year can have a substantial impact on wealth creation.
For example, $1,000 invested at an interest rate of 5% will grow to be worth $11,813 after 50 years. The same $1,000 invested at an annual rate of 6% will be worth $19,218 after five decades, that's 63% more than the 5% return.
Compound interest works both ways, however. It can help you grow your wealth, but it can also take wealth away.
The costs of compound interest
Compound interest works against you when you borrow money. The average credit card interest rate is 17.21% in the United States, which implies that a $5,000 liability left unpaid for five years could grow to be worth $11,749.
The impact of compound interest here is even more devastating because interest is levied monthly. If interest only accrued on an annual basis, the total would be only $11,060 after five years.
And it is not just credit cards where compound interest can work against you. For investors, fees can also become a problem that detracts substantially from profits over the long term. Buffett wrote:
"The nature of compound interest is it behaves like a snowball of sticky snow. And the trick is to have a very long hill, which means either starting very young or living very — to be very old."
Watch out for fees
Assuming the S&P 500 yields an average annual return of 9% for the next 50 years, I calculate an investment of $1,000 could grow to be worth $74,355 with no fees charged.
However, an annual management fee of 1.5% would cut the total return to $37,189. In this scenario, an investor would pay a staggering $37,167 in fees over the investment period.
If the same investor could get the annual management charge down to just 0.1%, they would end up with a pot worth $71,000 at the end of the five decade time frame, having paid just $3,334 in fees and charges. As Buffett noted:
"Over the years a lot of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero. That is not an equation whose effects I would like to experience personally, and I would like even less to be responsible for imposing its penalties upon others."
The bottom line
These examples show why it is important to avoid high-cost borrowing and high investment charges if you want to grow your wealth over the long term.
These are not big or complicated changes. Every investor and saver can make the conscious decision to avoid taking on that credit card debt or paying a high cost for advice.
They are simple changes you can make to improve the impact compound interest has on your money and wealth over the long term.
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