Understanding the concept of compound interest may help you see why starting early can be one of the most important steps you can take towards reaching your financial goals.
Compound interest enables you to earn earnings on your earnings. The longer the funds are invested, the greater the opportunity for the earnings to multiply. Consider if you deposit $100 into a bank account, receiving 2% interest on January 1st.
If 2% compounds annually, $100 will earn $2 after one year. In the 2nd year, the interest calculates on $102 and at the end of the year, it will have earned $2.04. In the 3rd year, the interest calculates on $104.04 and at the end of the year, it will have earned $2.08. This means in the 4th year, you are now earning interest on $106.12. By the end of year 5, the balance in the account would be $110.41.
Think now if 2% were compounding monthly. After 31 days at the end of January, the account will have earned 17 cents. During February, the 2% interest applied to $100.17 and by the end of February will have earned 15 cents (a smaller amount since we are looking at 28 days instead of 31 days). In March, with 31 days and using a base of $100.32, the amount of interest earned would be 17 cents for a balance of $100.49. Continuing with the calculation of base x 2% x the number of days in the month divided by 365 days means at the end of year 5, the balance in the account would be $110.51.
If the interest is compounded daily, the interest is calculated on the balance from the day before with interest added. The calculation would be the base x 2% x 1 day divided by 365 days. Using the daily compounding of interest by the end of the 5th year, the balance in the account would be $110.63.
While the difference does not seem significant when you are reviewing $100 and compounding interest over 5 years, consider if you added a couple of zeros to that $100 and instead were calculating compound interest on $10,000. Compounding annually versus monthly versus daily would yield $11,041 versus $11,051 versus $11,063.
Consider a lifetime of saving towards retirement and what the difference is if you start saving at age 50, 40, 30, or age 20. If retirement age is 65, how many years do you have for the compounding to occur? If you start at age 50, there are 15 years for dollars to accumulate. If you start at age 40, there are 25 years to accumulate funds. At age 30, you have 35 years and at age 20, you have 45 years.
The details: A one-time investment of $10,000 on your 20th, 30th, 40th or 50th birthday
Using daily compounding with a rate of 5% annually
What will you have when you reach your 65th birthday?
| Balance at Age 20 | Balance at Age 30 | Balance at Age 40 | Balance at Age 50 | Balance at Age 60 | Balance at Age 65 | |
|---|---|---|---|---|---|---|
| Age 20 | $10,000 | $16,289 | $26,533 | $43,219 | $70,400 | $89,850 |
| Age 30 | 0 | $10,000 | $16,289 | $26,533 | $43,219 | $55,160 |
| Age 40 | $10,000 | $16,289 | $26,533 | $33,864 | ||
| Age 50 | $10,000 | $16,289 | $20,7893 |
This chart reflects having invested the same $10,000 with no additional investments for varying ages. What is this meant to show? The younger you start saving, the less you must save out-of-pocket. The earnings on the earnings have longer to grow!!
Whether you start at age 20 or start at age 50, this is also meant to show you that you will need to invest more than $10,000. If you start at age 50, you will need to invest an even greater amount than if you start at age 20 to have the same balance in the end.
If you start with $10,000 and you want to get to a million dollars by the time you turn age 65, what do you have to invest in getting there?
The details: A one-time investment of $10,000 on your 20th, 30th, 40th or 50th birthday
Using daily compounding with a rate of 5% annually
What do you need to invest monthly to reach $1 million by your 65th birthday?
| initial investment | monthly investment | # of months investment made | total dollars invested | balance at Age 65 | |
|---|---|---|---|---|---|
| Age 20 | $10,000 | $ 444 | 540 months | $249,760 | $1,001,106 |
| Age 30 | $10,000 | $ 825 | 420 months | $356,500 | $1,000,840 |
| Age 40 | $10,000 | $1,612 | 300 months | $493,600 | $1,000,322 |
| Age 50 | $10,000 | $3,645 | 180 months | $666,100 | $1,000,329 |
Pay close attention to the column labeled “total dollars invested”. The difference between starting at age 20 versus starting at age 50 to get to a million dollars is over $415,000 that you need to invest.
There are variables to consider. If you are investing in the stock market, you will not earn a steady 5%. Putting in $250,000 does not mean that you will necessarily have a million dollars at age 65. Compounding helps you get closer.
How much will you have if you have a lump sum to invest today? There is a calculation that can tell you how quickly you can double your money. It is called the Rule of 72. Take the rate of return you want to earn and divide it by 72. The Rule of 72 tells you how long it will take for you to double your money.
For example, if you think you can earn 6% – take 72 and divide it by 6. This indicates it will take 12 years for your funds to double. It tells you it will take 7.2 years for your funds to double if you are anticipating you can earn 10 %.
Consider if you put all funds in a savings account earning ½ of a percentage. That says it will take 144 years for your funds to double. Find a savings account that instead is paying you 1.5%, and it will take 48 years for your funds to double. Consider if you instead put your funds into the stock market and get 4%. This would say that your funds would double in 18 years. If you manage to earn 8%, it means you can double your money in 9 years.
The keys to what you will have in retirement or towards any other financial goal:
• the length of time you have for the compounding of your investable dollars
• the rate of return that you will be receiving
• how much you will invest initially as a lump sum
• how much you can add to that investment on a monthly or at least annual basis
I cannot emphasize enough how important that length of time and the compounding factor is.