by Casey Cavender

Created on: August 23, 2008

I'd like to start by paraphrasing an old riddle involving two young people who, in this case, are deciding what they'd like to do with their hard earned money. Each is looking to build a sizable nest egg, starting with but $1,000.

The banker offers two choices: One account, paying 10% compounding interest per year, the other account paying exactly $1,000 a year for the life of the account. One of the individuals, without hesitation, chooses the flat rate account; "I'll make my $1,000 again every year this way!" he exclaims. The other ponders the situation for a minute before confidently choosing the account promising compounding interest. The riddle is this: After, say, a career of 50 years, assuming no additional deposits or any withdrawals, who has the biggest nest egg?

After 50 years, the first individual has $51,000; 51 times what he started with. The other, who earned a paltry $100 interest the first year, now has an astounding $117,390.85, or just over 117 times her initial deposit. But how?

Albert Einstein once said, "The most powerful force in the universe is compound interest."

Our wise investor did in fact only make $100 in interest the first year, which was 10% of her $1,000. But what about the next year? She made another 10%, except that this time, she didn't have $1,000; she had $1,100, which earned her $110 in interest (10% of her $1,000, as well as 10% of her last years interest of $100). The following year thus brought not $110, but $121. The effect then continued to snowball for the life of the account.

Our first investor doubled his money first in just a year (to $2,000), then doubled it again (to $4,000) not in one year, but in two, before doubling it again in 4 years. And our second investor?

To calculate the time it takes for compound interest to double the original investment amount, one uses a mathematical equation called the Rule of 72. Fear not; the Rule of 72 isn't twisted college level calculus or a formula made especially for members of Mensa; it's simply 72 divided by the interest rate. So our second investor doubled her money in 72 divided by 10, or 7.2 years. Only she didn't double it again in 14.4 years; she doubled it again in the same 7.2 years because the interest rate hadn't changed and the Rule of 72 is always in effect.

Realistically, we continue to deposit into our IRAs and 401Ks throughout our career; so what if both our investors deposited another $1,000 at the beginning of the second year? The first has $52,000, simple enough. The second? After the first year's interest, and the new deposit, she has $2,100 in the account. After another 49 years, she has $224,109.81; an increase of $106,718.96, far more than the single additional deposit of $1,000.

Now, in a real life scenario, it's difficult to find an account like either of the examples used here, and investing involves real risk, but the advantages of compound interest is clear. Imagine if that $117,390.85 account was left untouched for our investor's children's retirement in another 50 years?

In summary, put a little away and let compound interest work for you.

Can you really afford not to?

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