The REAL Magic of Compound Interest

It has been rumored that Einstein was asked what the greatest invention of his time was and he replied, “Compound Interest.”

I did the research and it is pretty certain that he didn’t say this but it would be ranked as one of the greatest inventions of the 20th century.

I’m sure all of you know what compound interest is and your financial adviser may have beaten this into you so I’m not going to explain it. I’m just going to show you how to use it properly. You will find these examples very interesting and enlightening.

Example 1: The Path of 3 People With the Same Intentions

Let’s say Shawn, Steve and Jack are all 25 years old. They all have finished college and have been working for the last few years making the same amount of money. They all have dreams of retiring rich and but have some difficulty making ends meet since they pay themselves last. However, they all are told to take a seminar provided by their HR department at work about saving for retirement and encouraging them to pay themselves first. After the meeting, they all agree that saving for retirement is important. However they all take different routes.

Steve decides to pay himself first. He sets up an automatic payroll deduction to an investment account that will yield and average of 8% and lives below his means. He invests $2000 per year into this account for the first 10 years until he is 35 years old. At that time he stops and never puts in a dime until he is 65 years old. At that time, he looks at his statement and he sees that his portfolio is worth a whopping $318,000!

Shawnon the other-hand says that he really can’t afford it right now since he can barely pay his bills as it is. He procrastinates thinking that he will invest as soon as he makes enough money. 10 years go by and he finally realizes that he needs to start saving for his retirement. He is still young at the ripe age of 35, so he figures he has time and it won’t make much of a difference. He visits his financial adviser and says, “I’d like to retire with the same $318,000 that my friend Steve will have when he is 65 years old.” His adviser tells him that is not a problem. Since he waited 10 years, all he has to do is invest $2600 per year for the REST OF HIS LIFE until he is 65 to accumulate the same amount that Steve saved in only 10 years.

Jackon the other-hand did what Steve did, but didn’t stop at 35 and kept putting in $2000 every year until he was 65 years old. His portfolio balance ended up at $559,562.08. Sweet!

The most important thing about compound interest is that you have to allow it time to work it’s magic. Without the necessary time, you will never see the true beauty of it. So start saving as much as you can now so you do not have to later.

Example 2: A Cheap Round of Golf

You and your friend decide to play a round of golf. He says to you, “Hey, let’s put a little bit of money to make it interesting. Le’s bet a dime on the first hole and every hole after, let’s double the ante to make the game more interesting as we get warmed up.” You confidently agree knowing that you are about the same level as him and you can’t lose that much money if you start from 10 cents. So you start your round with him and here is how the bets go.

Hole Wager

1 $0.10

2 $0.20

3 $0.40

4 $0.80

5 $1.60

6 $3.20

7 $6.40

8 $12.80

9 $25.60

So things are looking pretty good. The bets are still reasonable even though the bets have gotten a lot bigger over the last 3 holes or so. So you make the turn and start playing the back 9 trying to win some of your money back…..

10 $51.20

11 $102.40

12 $204.80

13 $409.60

14 $819.20

15 $1,638.40

16 $3,276.80

17 $6,553.60

18 $13,107.20

Wow! Now that is an expensive round of golf! Who would have though that you would be wagering over $13,000 by the end of the round starting from an initial bet of 10 cents.

This shows how important it is to never take money out of your retirement savings and to allow yourself enough time for your money to grow. By taking taking money out early, you are in essence taking away the amount of holes you play. If you played 5 less holes you would only be betting $409 instead of $13,107 by the end of the day! That’s 32 times smaller than if you played a full 18 holes!

Do yourself a favor, pay yourself first because if you don’t it will be too late. That means have your retirement as well as your savings directly taken out before it even hits your bank account. You my feel right now that you can’t afford the $40 it takes per week to save $2000 a year but what other choice to you have? You can’t afford not to. If you are not comfortable with that amount then start smaller. Start with $10. Open an ING Direct account or any other on-line bank. (This prevents you from being able to withdraw it on a whim.) You can print out a form and give it to your HR person to start the automatic withdrawal. It may be be uncomfortable for the first month or 2 but soon you won’t even notice.

There is nothing better than to know that your future is secure and that you have money in the bank so you are ready for anything life throws at you. Remember that compound interest takes a while to get revved up but once it does, wow! Every year you allow it to grow, the rewards increase exponentially.

I hope you found these examples interesting. It’s just a different way to look at it.

BTW… click here for a compound interest calculator that can assist you with figuring out how much you need to put away for your retirement.