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The Beauty of Compound Interest

The Beauty of Compound Interest

Albert Einstein once said the most powerful force in the universe is compound interest. My goal is not to have a religious discussion here haha, but rather a focus on just how incredible compound interest really is!

From Investopedia, let’s get a definition – “Compound interest (or compounding interest) is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Thought to have originated in 17th century Italy, compound interest can be thought of as ‘interest on interest,’ and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.”

If you love finance, compound interest is the core principle with which we work!

Now, there’s an important concern in our society. Many have not saved enough for retirement. Now, everyone’s needs in retirement will be different, but being prepared is very important. And the closer you get to retirement, the harder it is to make up time (hence Einstein’s quote). You’ve probably seen the statistics. Here they are (study done by nerdwallet.com):

Age Range:

Median Household Retirement Savings:

Under age 35

$ 12,300

Ages 35 to 44

$ 37,000

Ages 45 to 54

$ 82,600

Ages 55 to 64

$ 120,000

So, let’s do a quick case study in connection with investing. We all have heard, and I’m sure most have lectured their grandkids about, this particular principal, but it is super important.

We will have three examples of individuals starting invest at different times. Let’s see how they did. To make it simple, let’s just assume all money’s grow at 7% compounding annually:

Michael – Starting at age 20, (Michael was the most popular name in 1998), he is in college, works 20 hours a week while going to school. He is super busy, works the whole summer to help prepare for his next year’s tuition. He’s always been taught to invest, but he just doesn’t have a ton to set aside. He is committed to putting aside 300 per month and invests that annually. He wants to retire at 65. Michael doesn’t change the amount that he invests, ever. He uses the extra amount for his enjoyment and paying off college loans, as well as future expenses. By the time he turns 65, his balance is $1,104,306.

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Jennifer – Starting at age 40, (Michael was the most popular male name in 1978 as well… weird. Jennifer was most popular female name). Jennifer “forgot” to invest early and focused on other things. Now that she is 40, she came across a great article that convinced her to finally start investing. Her goal was to get to $1M dollars by age 65. Using her fancy calculator she found via Google, she realized she needs to put in $1,333 per month to reach her goal. In total, at age 65, her balance would be $1,098,824.

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Lisa – Starting at Age 50 (Michael was STILL the most popular male name in 1968...Lisa was most popular female name). Lisa is in a predicament. She is just getting to the point of becoming an empty nester and was looking forward to having extra cash flow to start traveling early. But, she decided she needs to get something in the bank to prepare for her eventual retirement at age 65. To reach $1M saved, she would need to put in $3,000 per month with the time frame she has. In total, at age 65, her balance would be $1,003,970.

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In summary, let’s look at the table:

Name

Start

Stop

Annual Contribution

Rate of Return

Ending Amount

Michael

20

65

3,600

7%

$1,104,306

Jennifer

40

65

16,000

7%

$1,098,824

Lisa

50

65

36,000

7%

$1,003,970

We all know it’s a good idea to prepare for the future, but having it put on paper helps us see the massive difference between starting early vs late. Compound interest is a thing of beauty, this is sure.

 

 

The examples presented are hypothetical and are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.

 

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