Recently when I did a talk for a group, I brought up the topic of magical compound interest and there were a lot of questions about how that works.. so today I’m going to try to mostly explain the positive side of Compound Interest.
Compound interest is a bit like fire, it can be harmful or helpful for you depending on whether you are paying it or whether you are receiving it. Either you're cooking with it and get to enjoy its delicious rewards or it can burn you!
Compound interest is basically growth of your money but fast tracking growth!
“On the positive side, the magic of compounding can work to your advantage when it comes to your investments and can be a potent factor in wealth creation. Exponential growth from compounding interest is also important in mitigating wealth-eroding factors, like rises in the cost of living, inflation, and reduction of purchasing power.”
Compound interest is a very important concept in finance, so much so that Albert Einstein allegedly referred to it as “the eighth wonder of the world.”
He also said that
“those who understand compound interest.. earn it
those who do not understand it...pay it.”
From a personal finance perspective, it is very important to make sure you are benefiting from compound interest rather than suffering from it.
There are a couple important factors that pertain to Compound Interest.
The first is,
Time:
"Time is your friend. The longer you can leave your money untouched, the greater it can grow, because compound interest grows exponentially over time."
(https://www.thebalance.com/compound-interest-4061154)
The sooner you start saving and investing, the easier it will be for Compound Interest to work it’s magical mathematical property of accelerating your savings and investments!
For example:
Year One: An initial deposit of $1000 earns 5% interest, or $50, bringing your balance to $1050.
Year Two: Your $1050 earns 5% interest, or $52.50; your balance is now $1102.50
Year Three: Your balance of $1102.50 earns 5% interest, or $55.13; your balance is now $1157.63
Frequency:
How often are you depositing money? From a behavioural standpoint, it is easier to save frequently and consistently and even automate your money towards saving and investing. Unfortunately, if you held onto it until you had a larger amount, most likely you would find another use for it before it got to its saving and investing purpose.
Starting Amount:
If you start with a larger sum of money, compound interest can work faster for you compared to a smaller amount.
Interest Rate:
Most of the time, interest rates sound like small numbers but usually those small numbers still add up, especially over time.
Today we are going to discuss when compound interest works in OUR favour! Maybe another time, we will talk about the negative results of compound interest.
Story Time:
There was a twenty year old woman named Pays to Start Young Sally. She realized early on the importance of having financial goals and dreams and wanting to make those become a reality. Sally, had older parents who were already retired but were barely able to pay the cost of their basic living expenses even on their Canada Pension Plan. They didn’t have any debts but yet they were barely scraping by because they had no savings. When they were younger, they were unwilling to set any money aside because they had spent all of their income on various trips and vehicles and after making those monthly payments, there was never enough money leftover to go towards savings. They always thought there would come a day when the payments would stop and they would be able to start saving towards retirement but that day never arrived. Unfortunately, the retirement years snuck up on them quickly and as soon as they retired, their income was reduced down to 25% of what they made prior to retirement and this started to pose a problem.
Sally watched her parents struggle and decided that she did not want to be barely scraping by when it was her turn to retire. Instead, she was going to make changes in her life. She made a goal for herself that no matter what, she was going to have a nest egg of a million dollars by the time she turned 65.
So, she spoke to some wise friends about how the best method of doing this and learned about the magic of compound interest. She played around with some compound interest calculators and made a financial plan that included setting aside $400/month towards saving and investing to help her reach her goal.
According to the calculator, if she diligently set aside $400 each month and received a moderate 6% interest rate throughout those 45 years then she could potentially have One Million dollars by age 65. Now, she knew that the interest rate would never stay the same from month to month let alone year to year but on average over time with gradual growth, she could achieve a 6% interest rate.
As the years went by, Sally sometimes grew tired of setting aside this large sum of money each month. It seemed really grueling the first year especially when she wasn’t making very much and during those years when friends were getting larger and larger homes and better and better vehicles and when childcare costs were increasing, but still she stayed faithful. She did whatever it took to set aside $400/month. Whether that meant bringing in extra income with side hustles or cutting costs where she could.
However, eventually she started to reap the benefits of staying on her financial plan. Finally, Sally noticed that the amount of money that she had gained from her interest was more than the monthly money that she had contributed from her own pocket. It took at least twenty years into the plan for her to see these rewards but she knew from the beginning at age 20 that she was in this for the long haul!
By the time Sally turned 30 years old, her friend named Later in Life Lucy, started to notice that Sally was very frugal and had heard Sally mention her savings goal of One million dollars by age 65, which piqued Lucy's interest. Lucy wanted to learn more and questioned Sally about her method of reaching this lofty goal. When Lucy learned that Sally had already accumulated $65,000 in Investments towards retirement, she wanted to start doing the same so she copied her friend and started to set aside the same amount of money also. Lucy, diligently set aside that $400 per month throughout the difficult times and throughout the tough economic ups and downs, until she eventually got to 65 years old.
Many years went by.
Lucy and Sally had not seen each other for a decade and suddenly ran into each other at age 65. Lucy, invited Sally out for a coffee date to catch up. Lucy, thanked Sally for teaching and encouraging her to set aside money for her retirement future even though it seemed like a long way away at the time.
Lucy, was curious and asked Sally if she had been able to accomplish her goal that she set out to do 45 years ago. To her surprise and delight, Sally had achieved her goal of building a nest egg of One Million dollars by age 65.
Sally, asked Lucy if she had also managed to achieve her goal.
Lucy, was a little bit timid, “well I didn’t quite make a million dollars but I do have half that amount." Sally was really impressed with Lucy and praised her saying "half a mission dollars is nothing to scoff at," and that she was really proud of her for staying true to the plan because she knew the sacrifice and work hard that it had required. Lucy beamed back at Sally. When the bill came, Lucy and Sally fought over who would pay it because both were feeling very generous.
Lucy was only slightly disappointed but she was still very happy that she had made the choice at the young age of 30 to start investing. After all, she ended up with $569,000 and only had to put in $168,000 of her own money. She could still remember, her high school math teacher telling her to work smarter not harder and she thought, here was a case of when she actually felt like she did this and it definitely worked out in her favour.
Have you ever played around with a Compound Interest Calculator?
My favorite one is on a website called Get Smarter About Money.com. Have a look, play around with the various calculators and see what could work for you and your family. Remember Personal Finance is 80% Behaviour and 20% Knowledge.
What would you like your Nest Egg Amount to be?
Now Go and Be Intentional!