Investing, Personal Finance Blog, Retirement, Saving

Invest Early, Retire Earlier – The Power of Compound Interest

Screen Shot 2017-09-20 at 7.26.09 PMThat’s a simple statement that has a very profound impact.  Aside from a handful of my fellow personal finance nerds, many people in their twenties are not really thinking about retirement at that age.  The earlier that we can get people to grasp the impact of time and compound interest, the better off they will be in their financial futures.

Let’s take a look at an example: Joe is a Black Sheep who starts investing at age 20.  Instead of blowing all of his money hanging out with friends every night for happy hour, he modestly invests $500 each month into a few low-cost index funds that return an average of 8% annually.

It’s not until 10 years later that Susie, at age 30, decides that she needs to start saving for her retirement too.  She invests the same amount as Joe does, $500/mo., in the exact same funds.  At age 50, Susie has invested a total of $126,000 over 21 years, but thanks to her investment returns and compound interest, she ends up with a balance of $326,740.53 – more than 2.5x what she put in!

On, the other hand, Joe started 10 years earlier than Susie, and only invested $60,000 more than she did.

How big of an impact does investing early make?

Screen Shot 2017-09-20 at 7.30.50 PM

Whoa!  Joe only invested $60k more than Susie did, but he ends up with close to $800,000 compared to her ~$327,000!  That’s $472,541, or nearly 245% more!

How does that happen? $60,000 ≠ (does not equal) $472,541.  Well, with the power of compound interest, it does!

What is compound interest?

It is interest paid on both the principal and the accrued interest.  Let’s break this mutha down… Watch:

Year 1: You invest $100 (principal) and earn 8% (interest) – your balance is $108 at the end of the first year ($100 x .08 = $8 interest earned)

Year 2: Your $108 investment earns another 8%, giving you a balance of $116.64 ($108 x .08 = $8.64 interest earned)

Year 3: Your $116.64 investment earns yet another 8%, giving you a balance of $125.97 ($116.64 x .08 = $9.33 interest earned)

At the end of the 3rd year, you still have only invested your original $100, but you have $25.97 in accrued interest.  In other words, your interest earned its own interest and your money made its own money on your behalf!  The longer you let this go on (i.e.: the more time you are invested), the greater the impact compound interest will have on your  returns.

But, can’t I just wait and invest more later in life?

Yeah, technically, but for every 10 years you wait before starting to save for retirement, you’ll need to save about three times as much each month in order to catch up.  Due to the power of compound interest, even a small investment made earlier in life can generate a larger amount than a larger investment made later in life.

As impressive as compound interest is, it’s even more impressive when you’re making regular contributions to your investments (as shown in the example above).

Albert Einstein called compound interest the “eighth wonder of the world.” To which he added: “He who understands it, earns it…he who doesn’t…pays it.”

You can avoid being on the back end of that statement by avoiding, or eliminating, debt.  Can you guess who’s getting YOUR compound interest while you’re in debt?  Your lender is!  And, by not investing, you’re also ‘paying for it’ because you are not earning the money that you could should be earning.

What is the risk of not investing?

An opportunity cost is a benefit that a person could have received, but gave up, to take another course of action.  In the example above, Susie’s opportunity cost for waiting 10 years to invest was $472,541.  She gave up nearly 1/2 million dollars, in exchange for the $60,000 that she did not invest during her first 10 years!  That is a life changing amount of money to forego.

  • Investing for a longer period of time is more effective than waiting until you have a large amount to invest.</li>
  • Not investing early, enough, or at all also places a huge burden of responsibility on your future self. Assuming that you are able to continue working in your later years, you are essentially committing yourself to a life of labor and dependency on an employer (or your own self-employment).

“Well, I’ll get Social Security, and that will probably be enough to cover my expenses.”  Good idea, the government has always been very responsible with its finances… You’re probably right, I’m sure everything will be just fine!

In Conclusion:

You can earn your share of this “eighth wonder of the world” by signing up for your company’s retirement plan immediately, and taking advantage of any company match they offer (free money).  If you are already maxing that out and are ready to save even more, look at Vanguard, Betterment or M1 Finance for low-cost investment options.

That is the power of investing early. If you didn’t start early, start NOW – and tell the younger folks in your lives to start reading the Black Sheep Millionaire Blog!  See also: How Much Do I Need to Retire?

 

 

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