Albert Einstein (i.e. a really smart guy) called compound interest the eighth wonder of the world.
In the world of personal finance, compound interest is the simple, but powerful concept of making your money work for you. It’s the idea that not only can you get a return on your invested principal, you can get a return on earnings too. What makes compound interest so amazing is the snowball effect it has over time.
Let’s look at an example.
If you put $25,000 into an investment that makes an 8% return each year and if all your returns get re-invested each year:
- at the end of 10 years, you’ll have $53,973
- at the end of 20 years, you’ll have $116,523
- at the end of 30 years, you’ll have $251,566
Why is it that your money grew so much more from year 20 to year 30, i.e. $135K, than it did in the first 10 years where it only grew $28K? The miracle of compound interest! It’s because each year your return got added to the principal amount of your investment so that the 8% annual return was being made on a larger base amount each year.
Compound interest works best when you give it time to work – this means saving early and often.
If you start early at age 25 and invest $10,000 per year for 10 years in an investment yielding 8% returns, by the time you are 55, you will have $787,567 (“Early Starter”). So, your total out-of-pocket investment of $100,000 (i.e. $10,000 per year from age 25 to 34) will return 7x!
However, if you wait until you are 35 and being investing $10,000 per year for the next 20 years making an 8% annual return, by the time you are 55, you will have just $544,567 (“Late Starter”).
So, even though the Late Starter invested double the amount of her own money as the Early Starter ($200,000 vs. $100,000), at age 55, she will end up with an overall portfolio value that is $240K less than the Early Starter ($787,567 vs. $544,567)!
Even if the Late Starter were to continue to invest an additional $10,000 per year for 45 more years until she is 100 and the Early Starter stops contributing at age 35, the value of the Late Starter’s investment portfolio still ends up being smaller than the Early Starter’s portfolio at age 100. In fact, the Late Starter will never catch up because the growth of the Early Starter’s portfolio will exceed the additional contributions made by the Late Starter!
For the Late Starter to be able to have the same amount as the Early Starter at age 55, the Late Starter would need to bump up her annual savings rate and invest $14,000 per year for 20 years from age 35 to age 55. This means that the Late Starter would end up putting in $280K of her own money, or $180K more than the Early Starter ($280K vs. $100K), in order to make up for the Early Starter’s 10 year head start.
If a person were to wait until age 45 to start saving and investing, in order to match the Early Starter’s portfolio value by age 55, that person would have to invest a staggering $43K per year, which means one would have to save and contribute $430K of his own money vs. the $100K for the Early Investor! Because there is so little time for compounding to help the very late investor, more than 50% of his portfolio will have come from his own contributions rather than earnings on his principal. Good luck with that!
So, what are the takeaways?
- Invest early and often
- You can’t make any investments if you have no money to invest. This means you need to save money early and often too.
- The earlier you can build your savings, the more you’ll be able to invest and the more time you give your money to grow.
- The longer you wait to start saving, the more painful it’s going to be to build up your portfolio, and you’ll end up having to put in a lot more of your own money to have the same amount as someone who saved and invested earlier than you.
