Define: Compound
One of the most important words to know in terms of personal finance.
Compound is also one of the most versatile words in the English language. According to Princeton’s Wordnet, there are 11 different definitions – from the military use of the word as a fortress or enclosure, to the basis of perfumes. But at the heart of the matter is mixing together two or more things to make something more intense, stronger or more marked. So perfume is a compound substance, stovetop is a compound word and blackberry is a compound fruit, as well as a modern technological addiction.
The strengthening effect is the part of the definition that applies most to personal finance. In “What To Know By Age,” we show you how less money saved earlier, through the power of compound interest, makes more money in the long run. See below:
Despite the fact that Some Guy managed to save $100,000 at age 45, our Smart Woman, who saved bit by bit earlier, actually ended up with more money - with the help of a 7 percent interest rate compounded monthly. The $40,000 grew each year as 7 percent was added to the principal. After the first year, she had $42,800 in the account; during the next year 7 percent of that was added on to the $42,800, increasing the total to $45,796 and so on until she had more than $450,000.
Compounding is everyone’s friend, but it especially benefits the young, as financial planner Mitch Glicksman of Evergreen Financial Associates (and one of our board members) points out. The longer your money has the chance to accrue compounding interest, the more it makes for you.
Compounding has its power in the frequency in which it is applied. The rate of interest, in the graph above, 7 percent annual interest, was compounded monthly. So the periodic rate (what is added to the principal each month) is .07/12, or .00583, or .58 percent added monthly. As you can tell from the chart above, it may seem like a small number, but it adds up over the years.
Most savings accounts and mutual funds will have compound interests and periodic rates associated with them (as will, unfortunately, most credit cards). Stock investments may add the dividend back into your investment, which has the same effect - your initial investment has now grown by the money your money has earned.
So if you're like us, you're probably happy to learn that the amount you've got going into your 401(k) or other retirement accounts is working as hard as you are, to make sure that your retirement doesn't involve those 6 dreaded words (yeah, one of them is "supersize").