Make Compound Interest Work For You
If you’ve ever learned anything about investing, I’m guessing you heard the phrase “compound interest”.
The principle of compound interest is fairly simple. When you invest, you earn interest. Then you have a greater amount of money, so you earn interest faster, creating larger and larger sums of money with no extra effort from you. Sounds pretty great right?
“Compound interest is the eight wonder of the world. He who understands it, earns it. He who doesn’t... pays it.”
Is Albert Einstein exaggerating?
Let me walk you through a short example of compound interest. You may even remember this one from your middle school math class.
If I offer you $1 million or $0.01 that doubles every day for 30 days, which would you choose?
Most people choose the lump sum of $1 million, because it seems impossible that a penny could ever grow quickly enough to reach such a large sum.
You might be surprised.
Let’s do the math:
Day 1 - $0.01
Day 2 - $0.02
Day 3 - $0.04
Day 4 - $0.08
Day 5 - $0.16
Day 6 - $0.32
Day 7 - $0.64
Day 8 - $1.28
Day 9 - $2.56
Day 10 - $5.12
Day 11 - $10.24
Day 12 - $20.48
Day 13 - $40.96
Day 14 - $81.92
Day 15 - $163.84
Those of you that chose $1 million are probably feeling pretty good right now. We’ve reached the halfway point and that penny has only turned into $163.84. Enough money for a nice meal or a new pair of shoes, but hardly life changing.
Let’s continue.
Day 16 - $327.68
Day 17 - $655.36
Day 18 - $1,310.72
Day 19 - $2,621.44
Day 20 - $5,242.88
Day 21 - $10,485.76
Day 22 - $20,971.52
Day 23 - $41,943.04
Day 24 - $83,886.08
Day 25 - $167,772.16
Day 26 - $335,544.32
Day 27 - $671,088.64
Day 28 - $1,342,177.28
Day 29 - $2,684,354.56
Day 30 - $5,368,709.12
The second half is where the magic happens. This is why time is such an important factor in compound interest. If you stopped after only 15 days, you’d have less than $200, but with a little more time you have over $5 million.
When compound interest works against us
Looking at the modern American consumer, credit card debt is incredibly common. Since a credit card allows us to purchase now, pay later, it’s easy to fall into the trap of thinking you can afford things that you can’t. Or, in the worst case, needing to pay for an emergency that you don’t have the money for. Banks take advantage and charge astronomical interest rates for you to borrow their money.
Take a look at my own credit card. Last month, I spent $1,727.05 on my credit card and it has a minimum monthly payment of $25.00. If I make no other purchases, and pay only the minimum, it will take me 11 years to pay off the balance, and I will end up paying around $4,200, more than double the original amount. (I know these numbers because my credit card provides them in my statements. Check your own statements and look for “minimum payment warnings”.)
With credit card interest rates ranging from around 15-30%, it’s no wonder that we struggle to get out of debt. With rates that high, people can spend their entire lives paying off debt. This is why it’s so important to understand how credit card interest rates work, and do everything you can to not spend more than you can pay off at the end of every month.
When compound interest works for us
The good news is, not all compound interest is bad. When it comes to investing, compound interest is the difference between a retirement in poverty or skirting around the world on cruise ships. I’m not exaggerating, it’s that important!
Let’s look at two examples. Both people save the same amount of money over a 40 year period, but one invests it and the other saves it.
For these examples, I’m going to assume both people put aside $500/month, starting at the age 25 and have a retirement age of 65. This means they’ll save $6,000/year for 40 years.
Person 1: Saving
Start - $0
10 years - $60,000
20 years - $120,000
30 years - $180,000
40 years - $240,000
After 40 years of saving, Person 1 has $240,000 for retirement. Now, that’s a lot of money, but if they live to age 95, will this money last them for 30 years?
In the next example, Person 2 sets aside the same amount of money, but they invest it in the market with a 7% return (this is the average rate of return for the market).
Person 2: Investing
Start - $0
10 years - $85,525.87
20 years - $253,768.19
30 years - $584.726.30
40 years - $1,235,771.00
Person 2 has over $1.2 million dollars for retirement. Wow!
But here’s the most important take away:
Both people contributed the same amount of money.
Person 1 and Person 2 both saved $240,000 for retirement, but Person 2 has over $1 million more because they invested it. That’s the power of compound interest.
Final Thoughts
Compound interest is arguably the most important principle of personal finance. It’s also why I urge you to start today. Even if you choose a poor investment that only has a 3% return, it is better than simply saving your money.
If you learn nothing else from me, let it be this: compound interest can be your best friend or your worst enemy. It’s the reason why you feel like you’re drowning when you have credit card debt. It’s also the reason you’ll be able to retire and travel the world.
Albert Einstein said: “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t… pays it.”
The question now is, which are you?
Your life may not be perfect, but it is imperfectly yours. The only way to live it is your way.
