December 22, 2016
Compound Interest and What it Means for You
This week I want to talk about savings, surprised? With the holidays upon us it’s possibly the worst time of the year to discuss savings, but that also means that the New Year (already?!) is nearly upon us. A time it’s imperative to have a plan – a plan that is challenging yet achievable, realistic but demanding. I’m not saying you should be scraping the seats of your car for loose change (like they say here at the office when lunch is picked up and I don’t have cash), but it’s important to live below your means. Earn more than you spend, spend less than you earn, and think about the future. That is where compound interest comes in.
We’ve all heard it, compound interest. Blah, blah, blah. However, let’s take a step back and look at the power of what Albert Einstein claimed to be the 8th Wonder of the World. Compound interest is the addition of interest to the principal sum of a deposit. Essentially, compound interest is interest on your interest. I look at interest as a reward for savings and interest on my interest as a reward for a decision that was made years ago. Yes, compound interest does take time, however not as much as you may think.
We can calculate compound interest by multiplying the principal amount by one plus the interest rate raised to the number of compounded periods minus one.
= P [(1 + i)^(n – 1)]
You’re probably asking yourself how do I get compound interest and how do I get more of it? There is a direct correlation between time and interest in the compound interest formula. Compound interest can only be achieved over time and the more time available with the more interest earned will yield more and more compound interest. I’m sure a lot of you have heard of compound interest, but just how powerful is it for Albert Einstein to call it the 8th Wonder of the World?
Let’s look at a scenario from an article from Business Insider. In the chart below Susan, who invests for only 10 years early in her career, ends up with more wealth than another saver (Bill), who saves for 30 years later in life.
The difference here is that by saving early, Susan took greater advantage of compounding interest than her peer did.
This chart is staggering to me. Take another look at it. Susan invests $50,000, with a 7% rate of return. She is investing $100,000 less than Bill and ends up with a larger sum of money due to the strength of compounding interest over time. By saving consistently until retirement and starting early, Chris ends up with over $500,000 more than Susan with only $150,000 more invested. Also, notice how steep Chris’ line is later in life as the exponential property of compounding interest kicks into high gear.
So let’s take a look at another scenario by Andy Kierz. In this scenario we once again look at the power of saving early. Emily, represented by the blue line, starts saving the exact same amount as Dave (the red line), with the same annual rate of return of 6%, but begins 10 years earlier. Ultimately, she contributes around 33% more than Dave over the course of her career, but ends up with twice as much wealth as he does.
Now you may say, “I’m not 25 anymore so this won’t work for me.” Wrong. You may be 35, 45, 55, or 65, but in 10 years you will be 10 years older than you are today and the relationship of the data in the chart above will remain true. Money saved today will be worth more than money saved in the future.
Unfortunately, we’re only graced with a certain amount of time on this earth and it is often not up to us just how much time we have. The truth is that there is no better time to start saving than yesterday. One of the founding principles of finance is: a dollar today is worth more than a dollar tomorrow. Not only does this statement factor in compounding interest, but inflation. As mentioned earlier, the greater the time the greater the compound interest, but there will never be more time than you have today.
With 2017 right around the corner, we recommend you speak to a financial professional at Gainplan to fine tune your savings strategy in accordance with your goals. We can recommend the most efficient savings vehicle for you and allow you to begin or continue your exploration of the 8th Wonder of the World. After all, we’re invested in you.
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