by Gary Foreman

Do you think time is no longer on your side when it comes to compound interest? Think again. You still have time for it to work for you…and against you.

Compound interest has been described as the eighth wonder of the world. And, in the financial world, compound interest may be the first wonder.

Using compound interest correctly can make your retirement finances more secure and safe. Misuse it and you could find yourself working a part-time job you don’t like to avoid running out of money.

Unfortunately, surveys show that people heading for retirement haven’t been using compound interest wisely. According to RamseySolutions.com, the average savings balance for people in their 50s is $160,000. It’s $182,100 for the people in their 60s. For most people, this won’t be enough to support their ideal retirement.

What Is Compound Interest?

Most of us are familiar with the concept of interest. If you put money in the bank, you’d expect to earn some interest. Suppose it was 10% a year (obviously unrealistic, but a good number for illustration). So if you had $100 on deposit for one year, you’d earn $10 interest on it (10% of $100 = $10).

Compound interest is earning interest on interest. Using our 10% interest example, the second year, you’d start with $110, so you’d earn $11 in interest the second year. The extra dollar is earning interest on your first year’s interest. This is compound interest.

The Value of Compound Interest

Compound interest is essential for savers because the interest you earn doesn’t require any additional work or effort on your part. It happens automatically! It’s as if someone is giving you money every year because you saved some money once in your life!

The real value of compound interest is that the longer it works, the more powerful it becomes. In our example, we earned $10 in interest in the first year and $11 in the second. In the third year, we’d earn $12.10, and each year would be more than the year before. Clearly, an extra $1 won’t make you rich, but if you’re saving hundreds or even thousands a year in an investment or retirement account, the interest earned can be significant.

The Danger in Compound Interest

Just like any powerful tool, compound interest has a dangerous side. It works against you if you borrow money. Let’s use our example. Suppose that you borrowed the $100 instead of investing it. And let’s further suppose that you paid $15 to the lender at the end of the year. Only $5 would go to reduce the amount borrowed. The other $10 would just pay off the interest owed. If you didn’t pay anything back, the balance would increase by $10 the first year, $11 the second year, etc.

A prime example of that is when student loan payments are delayed. Under certain circumstances, you can stop paying on your student loans for a time, but the interest keeps adding to the balance. It’s not uncommon for student loan borrowers to find that their balance has increased by 50% or more in just a few short years.

That might seem like a strange example for someone approaching retirement until you consider the stats. According to AARP, people aged 50 and up owe about 22% of the nation’s student loan debt balance. Often, when the student drops out or graduates but can’t find the salary they expected, the co-signer is left with the debt.

The Rule of 72 and Compound Interest

The rule of 72 is a rough tool that investors have used for years. It says that you can divide 72 by an interest rate to approximate how long it will take money to double in value. For example, money loaned out at 10% would take about 7.2 years to double (72 divided by 10 = 7.2 years). The same is true if you’re borrowing money.

Compound Interest and Time

Time and compound interest can be your best financial friend or your worst enemy. If you can save money in your 20s and 30s, you’ll reap the rewards of compound interest as you enter your retirement years.

If you’ve struggled financially and haven’t put anything aside for retirement, it’s still possible to use compound interest to your advantage. Paying off your credit cards is an excellent way to take advantage of compound interest. For every dollar you pay off early, you’ll be earning 15% or so.

And it’s not too late to save, even in your 50s or 60s. Life expectancy is in the mid-80s. For a couple that reaches age 65, there’s a 50% chance that at least one of them will live into their 90s. Therefore, you can still save money and have compound interest work for you.

Related: Playing Catch-Up With Your Retirement Savings

Ben Franklin’s Lesson and Legacy

Ben Franklin knew the power of compound interest. He wanted others to learn of its power, so when he died, he left $5,000 to Boston and $5,000 to Philadelphia. He had some rules on how the money could be used. It was to be used to create a fund that would last for 200 years. The money was to be loaned to the needy at 5% interest. At the end of the first 100 years, each city could withdraw a half million dollars from the fund. The rest was to be loaned out for the second 100 years.

As you might expect, the cities didn’t follow the rules precisely, but Ben Franklin made his point. Compound interest is a powerful financial tool. And that’s a lesson that’s important for every adult today.

• Could Debts Ruin Your Retirement?
• Your Emergency Fund In Retirement: A Comprehensive Guide
• How To Minimize 4 Risks to Your Retirement Savings
• How Credit Card Needs Change After Age 50
• What Retirees (and the Nearly Retired) Need To Know About Compound Interest

Reviewed October 2023

About the Author

Gary Foreman is the former owner and editor of the After50Finances.com website and newsletter. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.