Albert Einstein — ‘Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.’
This is my favorite and least favorite topic, depending on whether we are discussing investments or debt. For the sake of keeping this post awesome, my examples will be all about investments, but remember that compound interest works just as effectively against you if it is debt.
Say I am 25 years old, and I invest $1,000 and I get a 6% return each year. The first year, I am going to get $1,060. That’s not really that awesome, but it’s not so bad. $60 is better than $0. But then the next year, $1060 gets invested instead of $1,000, and you end up with $1123. Not too shabby… Your interest starts earning interest. You could almost call it…compounded!
If you leave your $1,000 alone (and if the interest rate is steady at 6%, for the sake of this example) in 40 years you will have $10,285. TEN TIMES AS MUCH MONEY AND YOU DIDN’T DO ANYTHING AT ALL.
|
Number of years |
Keep it in your mattress | Keep it in your checking (.25% interest) | Keep it in your savings (.8% interest) | Invest it at 6% |
|
0 |
$1000 |
$1000 |
$1000 |
$1000 |
|
20 |
$1000 |
$1111 |
$1233 |
$3207 |
|
40 |
$1000 |
$1168 |
$1446 |
$10,285 |
I thought, “Well, this author obviously doesn’t understand that if you invest more money you get more money at the end.” I felt like I didn’t have enough money to start investing and that investments are for people who already have money and if that isn’t a horrible catch-22 I don’t know what is!
Examples like this used to piss me off, because I never had $1,000 to invest, and I still don’t have $1,000 sitting in my bank account just waiting to be invested. When I was 24 I was living in a double wide trailer in rural Alabama (true story). A big activity for me was driving an hour to go to Walmart. I barely had any income at all, but you know what I did have? Fifty bucks. I put $50 into a retirement account every month (automatically! I don’t even miss it!), and I just let it sit. And you know what? Compound interest works on $50 too! If I stick to this schedule, in 40 years I will have put in $24,000 (and hardly noticed it was missing, because I automatically moved it) and I will have $93,206. That first $600 from the first year will be worth $6,171. WHAT? Awesome.
Imagine what I could have done if I had started at 18!
(Actually, the answer to that is that I would have paid $28,200 out of pocket and I would have $144,650 by the time I retire at 65. That extra $4,200 and seven years would be worth $51,400! Learn from my missed opportunities, all you 18 year old readers!)
Most of us are plagued by a lack of long term vision. We want cash now and are unwilling to be patient and wait 20 or more years. It’s refreshing to see blogs like this that address saving early. Time scoots by in a hurry, believe me!