Why Compound Interest Makes You Rich!



It’s one of the oldest clichés in investing: “Time” is an investor’s best friend.

Unfortunately, few people ever fully take advantage of this concept or grasp just how it works. So why is “time” an investor’s best friend? In two words:

• Compound interest.

There’s an urban legend that Albert Einstein once said that “compound interest is the most powerful force in the universe”. If he did, he was right. Consider two scenarios:

Which one would you rather have? How can it be that one is worth way more than the other?

This is the power of compound interest:

• Eventually you will make MORE money off the build-up of returns from your earnings than off the original money that you put in.

I will show you an example of why this is.

A Quick Clarification:

Technically speaking, there is a big difference between “interest” and “annual returns”.

• “Interest” is a payment of debt, like on a bond or savings account. In other words, it’s money that is owed to you.

• “Annual returns” are the change in value of stock prices. It’s not money that is owed to you, it’s just an expression of how much you could sell the stock for now that the price has gone up. When people say things like “the stock market returns 8% every year”, they’re talking about the value of the stocks going up each year on average, but that’s not the same thing as interest. This is also sometimes called capital appreciation or capital gains.

Definitions aside, the principles of “interest” and “annual returns” can be mathematically calculated the same way.

So How Does Compound Interest Work?

No algebraic equations here; there’s plenty of other Internet websites for that. The best way I can think to explain it to you will be to show you with an example:

Year 1:

• You start with no money saved, $0 (Starting Value)

• By the end of the year, you have $5,000 to invest (Contribution)

• Since you invested at the end of the year, you didn’t make any money (8% Return) (Math: $0 x 0.08 = $0)

• At the end of the year, you have $5,000 (Ending Value)

Year 2:

• You start with the money you had at the end of Year 1, $5,000 (Starting Value)

• By the end of the year, you have another $5,000 to invest (Contribution)

• During the year, you make an 8% return on the money you had at the end of Year 1 (8% Return) (Math: $5,000 x 0.08 = $400)

• At the end of the year, you now have a total of $10,400 (Ending Value) (Math: The initial $5,000 + the $5,000 contribution + $400 return).

Year 3:

• You start with the money you had at the end of Year 2, $10,400 (Starting Value)

• By the end of the year, you have another $5,000 to invest (Contribution)

• During the year, you make an 8% on the money you had at the end of Year 2 (8% Return) (Math: $10,400 x 0.08 = $832)

• At the end of the year, you now have a total of $16,232 (Ending Value) (Math: The initial $10,400 + the $5,000 contribution + $832 return).

And so on and so forth. For as long as you 1) keep making $5,000 contributions, 2) keep earning 8%, and 3) don’t take any money out, your money continues to grow every year in this fashion until eventually it looks like the graph shown below:

For illustration, your money shown in the graph has been divided between two sources:

• Blue – The Principal – The amount you put in

• Purple – The Returns – The amount that grew on top of your principal (and past returns)

As you can see, after a certain number of years, your returns start to build and eventually out-pace your principal, causing your money to grow out of control! This is what makes compound interest so incredible!

How Does This Make Me Rich?

Point 1:

Now that you understand that your money will start to grow out of control after a certain investment of time, the real question becomes “How soon can I get started?!” This is why people say things like “the earlier you start, the better!” when they are talking about your 401k or IRA. As you can see, the sooner you start, the more you stand to make!

Let’s look at an example of the difference between starting at age 25 versus age 35. Assuming you put away $5,000 each year, got an 8% return, and planed to retire at age 65, how much different would your potential return be?

Ouch!! The “age 35 portfolio” would be just under half of the of the “age 25 portfolio”.

You might say, “But I can’t afford to put money away now! I’ll start later on when I make more money and put more in to catch-up.” Okay, let’s run that example too. We’ll compare starting at age 25 by putting away $5,000 per year versus starting at age 35 and putting away $10,000 each year (and all the other variables are the same). Now who comes out ahead?

Ouch again! The “age 25 portfolio” still comes out on top. And even though they are close, which would you rather have: $5,000 taken out of your check each year or $10,000 taken out of your check each year? I know which one I’d prefer!

Here’s what I want you to take away:

• Start your savings right away! A 401k. An IRA. Both! Your maximum return always starts right now!

(To read my introductory post on 401k’s, click here)

(To read my introductory post on IRA’s, click here)

 

Point 2:

The power of compound interest is one of the simplest forms of passive income available. In fact, that’s how most people plan their retirement: By building a pile of cash so big that they can live off the returns it produces. Although it takes time, as you can see, it will far surpass just keeping your money in traditional or low-interest savings.

You will never truly get the same rate of return forever; in fact, some years in may be negative. We only used a single positive annual return for simplicity in these examples. However, keep in mind that it is possible to get decent “average” rates of return depending on your preference for asset allocation (your selection of stocks, bonds, etc.).

Regardless of how you structure your portfolio and the rate it returns, here’s what I want you to take away:

• For as long as you continue to stay disciplined and make contributions, continue to get a good rate of return, and don’t take the money out, your money will grow, grow, grow with virtually no effort on your part!

I’m no Einstein. But the beautiful part is that you don’t need to be. Compound interest really can be the most powerful force in the universe. And the best part is that anyone can take advantage of it. Don’t wait to be proved wrong!

Comments

    • MMD says

      Awesome! I hope it serves as a reference for you in the future as well as a reminder about how investing works. The sooner you can leverage its power, the better off you’ll be.

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