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The Power of Compound Interest
Compound interest is the most powerful force in the universe.
— Mignon McLaughlin. N.d. BrainyQuote.com. Retrieved October 24, 2015, from
BrainyQuote.com website:
http://www.brainyquote.com/quotes/quotes/m/mignonmcla158995.html
. There is some
controversy about whether this statement was made by Albert Einstein, but he clearly
made similar statements highlighting the power of compound interest.
In Element 4.3 we emphasized the importance of budgeting regularly, saving habitually, and
spending your money effectively. There are two major reasons for starting earlier rather than
later. First, as discussed, those who yield now to the many excuses not to start budgeting,
saving, and spending wisely will have a hard time doing so later. But in this element we want
to talk more about the second reason to begin saving right away: the big payoff that comes
from starting early.
A small head start in your savings program leads to a substantial increase in the payoff.
Recall the example in Element 4.3 of the additional retirement wealth a young person could
have by saving a modest amount from age twenty-two to thirty. Giving up just a little more
than €9,000 in purchasing power for those nine years can easily add over €150,000 to
retirement wealth at age sixty-seven. The key to converting a small amount of money now into
a large amount later is to start saving immediately to take full advantage of the “miracle of
compound interest.”
Compound interest
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is not really a miracle, but sometimes it seems that way. It’s also
not necessarily just interest—if you keep money invested in the stock market and reinvest all
ELEMENT 4.7
Make compound interest (returns on investment) work for you.
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the gains you get, that’s also a compound return, which we sometimes call compound interest
for the sake of simplicity.
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Despite the fact that it is easy to explain how compound interest
works, the results are truly amazing. Compound interest is simply earning interest on interest.
If you don’t spend the interest earned on your savings this year, the interest will add to both
your savings and the interest earned next year. By doing the same thing each year in the future,
you then earn interest on your interest on your interest, etc. This may not seem like much, and
for the first few years it doesn’t add that much to your wealth. But before too long your wealth
begins growing noticeably, and the larger it becomes, the faster it grows. It’s like a small
snowball rolling down a snow-covered mountain. At first it increases in size slowly. But each
little bit of extra snow adds to the size, which allows even more snow to be accumulated, and
soon it is huge, growing rapidly, and coming right at you.
The importance of starting your savings program early is explained by how compound
interest sets the stage for its accelerating effect later. The savings you make right before
retirement won’t add much more to your retirement wealth than the amount you save—a little
but not much. The snowball that starts near the bottom of the mountain won’t be much bigger
when it stops rolling. So the sooner you start saving, the more time that early savings will have
to grow, and the more dramatic the growth will be.
Consider a simple example. Assume a sixteen-year-old is deciding whether or not to
start smoking. This is an important choice for several reasons, health considerations being the
most important. In addition to the health factor, however, there is a financial reason for not
smoking. The average price of cigarettes in Europe varied from about $3 to $13 a pack in
2017,
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so let’s assume for simplicity that it is $8 per pack. So if our teenager—let’s call him
Honza—decides against smoking, he will save $2,920 a year (assuming he would have smoked
a pack a day). Suppose that instead of spending this amount on something else, Honza invests
it in a retirement account or fund that earns 7 percent per year and is protected from income
taxes. As Exhibit 24 illustrates, if Honza keeps this up for ten years, when he is twenty-six he
will have accumulated $40,344 from savings of $29,200. Not bad for a rather small sacrifice—
one that is, in fact, good for Honza.
But this is just liftoff; the payoff from compound returns is merely getting started. If
Honza keeps this savings plan going until he is thirty-six, he will have $119,707 from savings
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of $58,400. Continuing until he is forty-six will find him with $275,825 from savings of
$87,600. And now the afterburners really start kicking in. By the time Honza is fifty-six he will
have $582,935 from saving contributions of $116,800. As Exhibit 24 shows, when he retires at
age sixty-five he will have $1,106,677 from direct contributions of only $143,080. Thus, by
choosing not to smoke and investing the funds, Honza accumulates about $1.1 million in
retirement benefits—and this figure is in dollars with today’s purchasing power.
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