Compound Interest is the 8th wonder of the world
When I was a kid, I would walk into the bank to deposit something like $50 of soda selling money, and I would be so excited to see how my money had grown since the last time I had an account update.
There was no online banking. I had a bank-provided ledger book that the teller updated in ink pen for me every time I deposited money in my savings account. I wasn’t entirely sure how it worked in those early adolescent years, I just knew my money was supposed to grow by giving it to the bank.
I learned the details of the time value of money and compounding interest in middle school.
FV = PV x (1 + r)n where:
FV: Future Value
PV: Present Value
r: rate of return
n: number of periods
This is simply telling you what your money today will be worth in the future given the set of assumptions shown. For example, if I hadn’t saved a dollar since I started tracking my net worth in December 2010 and just wanted to know what that $30,000 is worth now (let’s say December 2018 for simplicity) at varying market conditions (let’s assume the market has averaged 8% gains in that time) then I would have:
FV = 30,000 x (1 + 0.08)8 = 55,528
A simple rule is that it takes about 10 years for your principal to double at 7% interest.
As many financial advisors will tell you, the power of compounding interest starts slow, but increases at exceedingly rapid levels the longer you extend the math.
After 20 years that $30,000 should be worth $139,828
After 30 years: $301,879
After 40 years: $651,735
Not bad that $30,000 of adolescent savings would be worth over $600,000 when I’m 63 years old.
Parents, teach your kids to save. Save early, save often. Many articles start hypothetical scenarios for saving for retirement at age 20. Why can’t you start at age 10 and add another decade of compounded interest to the math for retirement years?
The learning will compound as you teach your teenager positive financial habits, saving, frugality, and the power of math for watching your money grow.
Now lets say that I contribute $100 per month, or $1200 per year, to my retirement fund, starting back at the end of 2010.
The formula for that is:
FV = A [(〖(1 + r)〗^n -1)/r ] where A is the annual contribution.
FV = 1,200 [(〖(1 + 0.08)〗^8 -1)/0.08 ]= $12,763
If I had started doing that in December of 2010, I could add that money to the new worth of my original savings of $55k, totaling approximately $68,000.
Again, the value is from the many years of allowing this savings to compound.
After 20 years of $1,200 annual contributions I would have saved $54,914
After 30 years: $135,939
After 40 years: $310,867
If you add that money to the future value of my original savings, I’ve got just shy of a million dollars of net worth. We can all find $100 a month in our budget to put toward retirement, can’t we?
Further, if you can avoid/minimize lifestyle inflation as you get older and your earnings increase, you can save more than $100 a month in your 30s, 40s, and 50s to grow these example dollar amounts much larger.
How do you avoid lifestyle inflation?
- Every time you get a raise – be it cost of living for inflation or merit based – you should set aside some (or all!) of that extra money in your paycheck to pay yourself first in your retirement savings.
Mrs. OneDollarAllowance here – This is how I handled my early retirement savings. I thought the concept of putting money towards something so far away, while I was barely getting by with living expenses in college, was ridiculous. My parents said, “at least put in what gets matched.” So I did. Six months into my part-time job, I graduated college and was hired full time, with about a $10,000 raise. With all of that extra money and no extra expenses, I should have maxed out my retirement, but I was a dumb kid. I increased my retirement savings, but didn’t max it. It wasn’t until I met Mr. OneDollarAllowance that I was pushed to contribute to all retirement accounts fully.
- Don’t rush to go buy the next big gas guzzling SUV. Drive your cars longer and buy vehicles that are more fuel efficient and reliable at higher mileage levels.
- Don’t go buy that big dream house in your 20s. You don’t need to keep up with the Joneses. Remember that people don’t post the negative side of their lives on social media. If you compare your life and your belongings to the people you see online, you’ll do yourself and your finances a disservice.
- Curb your craft beer and your fancy restaurant tastes. These are good to treat yourself to every now and then to maintain your sanity, but eating out is the biggest thing I see my generation spend their money on, watching their paychecks disappear every two weeks.
There are countless examples of ways you can flex your frugality muscles, but I’ll leave those for a future post.
Let’s go back to the numbers for increasing retirement savings and see what happens. We’re going to save $100 a month for the first decade, $200 a month for the second decade, $300, then $400 for the last decade.
|Principal||End 10 yrs||End 20 yrs||End 30 yrs||End 40 yrs|
|Starting $||$ 30,000||$ 64,767||$ 139,828||$ 301,879||$ 651,735|
|First Decade||$ 12,000||$ 17,384||$ 37,530||$ 81,024||$ 174,923|
|Second Decade||$ 24,000||$ –||$ 34,768||$ 75,061||$ 162,048|
|Third Decade||$ 36,000||$ –||$ –||$ 52,152||$ 112,591|
|Fourth Decade||$ 48,000||$ –||$ –||$ –||$ 69,536|
|Total||$ 150,000||$ 82,151||$ 212,126||$ 510,116||$ 1,170,834|
There are several takeaways from this chart.
- It’s surprisingly simple to amass wealth purely from discipline and deliberate, consistent saving.
- In 40 years, your money multiplies quickly compared to the principal you invested.
- The amount of time you invest is far more important than the amount of money you invest. Note that the money that had 40 years to grow nearly had triple the effect of the last decade, which was 4 times as much money, but only had 10 years to grow.
- The starting principal made up 20% of total money invested, but its value after 40 years is 55% of the total.
In summary, it’s never too late to start saving, and the worst thing you can do is continue putting it off until tomorrow. The earlier you put money away and let it grow, the more it is worth when it’s time to tap into those funds.
I remember having about $450 to my name at about age 10. That money is worth approximately $2,200 now, and should be worth about $22,000 when I’m in my 60s. Not bad for selling sodas out of a wagon for a couple summers and then just not spending that money.