Compound interest (the most powerful force in the universe)
What if I told you that as a 20-something year-old, every dollar that you put away could equal $7 by the time you retire? What if I told you that the $25,000 Toyota Prius you just financed just cost you two to three extra years of your working life vs buying a similarly-reliable $8,000 Honda Civic that will still get you from point A to point B? Or that the extra $100,000 you spent treating yourself to your dream home at age 30 would have amounted to an extra $500,000 (nearly half of what you’ll need to retire) by age 65?
This is the power of compound interest, when used to your advantage.
Urban legend has it that Albert Einstein once jokingly claimed compound interest to be the most powerful force in the universe. While that may be a bit optimistic, the earning potential behind it is still a boon that should be thoroughly understood – especially at an early age, when you can take maximum advantage of its power.
And while the concept is fairly simple, I wish somebody had sat me down at 18 and really took me through the meaningful implications behind it, and its potential for influencing my life outcomes. I will try to do this for you now.
Compound Interest Explained
The basic formula for compound interest (calculated on an annual basis, to keep things simple) is as follows:
A = P * (1 + r) ^ t
A = ending amount, P = initial amount (principal), r = interest rate (eg. 0.05), t = time in years
So, for example, if your savings bank advertises a 0.05% interest rate, and you deposit $1000 today (say you are 25), what will its value be in 40 years when you are ready to retire? The answer is a mere $1020 (side note: did you calculate it to be $7040? Note that an advertised 0.05% interest rate is not the same as 5%, but rather 0.05 percent, or 0.0005 – a marketing nuance that banks may use to trick you out of potential earnings).
Now let’s say you invested the same $1000 into the stock market – into a mutual fund that generates 7% per year, on average. After keeping it there for 40 years, what would be the value of your investment? The answer is $14,794 ($1000 * (1 + 0.07) ^ 40).
We are still forgetting about one thing – inflation. Due to the constant general year-over-year increase in the price of goods and services, the value of a given US dollar falls by approximately 2% each year. To get a realistic picture of what our future money will look like in today’s dollars, we must reduce the interest rate by this amount.
Looking back to our savings account example, the 0.05% advertised interest rate effectively becomes -1.95%, turning our $1000 not into $1020, but into $455 after 40 years. Any money earning less than 2% interest is actually losing value each year.
In the example where we invested our money, our $1000 turns not into $14,794, but rather into $7040 – still a very generous figure.
These are called inflation-adjusted amounts, and they give us a better mental image of what our money will actually be worth to us at that point.
Because I care so much, I’ve made you a super-awesome compound interest calculator spreadsheet, so that you can fool around with these calculations yourself:
Spreadsheet – Compound interest calculator
Earning potential
Armed with the above information, how can relate this formula back to our own lives? What are some conclusions that we can draw? Here are some of the more striking ones:
Every dollar that you DON’T spend…
- At age 21 could be worth 8.5 times as much when you’re 64.
- At age 30 could be worth 5.5 times as much when you’re 64.
- At age 45 could be worth 3.4 times as much when you’re 64.
If you invest $500/mo in your retirement starting at age…
- 21, you’ll have earned $700,000 in free money by age 64 ($950k total).
- 30, you’ll have earned $360,000 in free money by age 64 ($570k total).
- 40, you’ll have earned $150,000 in free money by age 64 ($300k total).
At age 25, if you invest…
- $650/mo in your retirement, you’ll be able to retire at 64.
- $1000/mo in your retirement, you’ll be able to retire at 57.
- $1500/mo in your retirement, you’ll be able to retire at 51.
NOTE: I am assuming that every dollar invested earns an average of 7% year-over-year, with a 2% inflation rate – a very common goal. I am also assuming a $1,000,000 retirement goal, which should allow for a passive permanent income of $50,000/yr, independent of any other retirement income (ie, Social Security).
If you were surprised by the above assertions, you’re not alone. According to this 2016 study, 62% of Americans failed a survey testing basic financial concepts such as compound interest, risk, and inflation. Take a moment to really understand these statements, and draw your own conclusions.
The time for saving is now
By now you should have a fairly meaningful grasp on the concept of compound interest, and of the earning power behind it (seriously, there’s a literal power operator in the formula for it!).
It should also be mentioned that it is worthwhile to stay on the positive side of compound interest – just as your savings and investments earn interest for you, your debt – your mortgages, credit cards, and auto loans – are earning interest against you (for the bank). For more helpful information on where to put your money, read this article.
As we get older, the heightened earning power behind compound interest starts to wane (exponentially so), and the window of opportunity for gleaning huge profits at relatively little cost begins to close. If I could make one positive impact on our collective financial regimen, it would be for society to heed the following advice from a relatively young age: Understand fully the opportunity cost behind each expenditure. This is one of the most important lessons you can learn for securing your own financial future.
And while it is fully possible that if I were somehow to have read this article at age 20, I would have saved myself into a boring, dry, young-adulthood, knowing this information before the clock runs out has made all the difference.
