Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Who are we to argue?
Compound interest is when interest is earning interest not just the original capital. I.e. you invest $100 at an interest rate of 5%. After year one you have $105. After year two however, not only does your original $100 earn another 5% interest, but the extra $5 is also earning 5% interest so that at the end of year 2, the money has grown to $110.25. Yay an extra 25 cents. Where compounding really gets interesting is when you extend it over long periods of time.
Let’s take two examples. Example 1 is a 25 year old who has a decent income and is able to put away $100 a week into an investment that generates 6% p.a.
In the second example, however, the person tends to spend all of their money on fun stuff, living life to the fullest until the age of 45 where they decide to start saving for retirement. They are on quite a bit more income than the first person who is only 25 and instead of being able to save $100 a week, they can save $400 a week.
Person 1 ends up with approximately $861,457 at age 65 after contributing $213,200 over the 40 years.
Person 2 ends up with slightly less at approximately $835,851 at age 65 however they have astoundingly put in $436,800. Over twice as much as person 1. Imagine what person 1 would have been able to do with the extra $224,600 that they didn’t need to contribute over the last 20 years? Me personally, I’m thinking holidays.
While returns are important when investing, the single most important thing that can grow your wealth the most is time. Compound interest makes this possible, and so when is the right time to start saving? No matter how old you are, the right time to start saving is right now.
PS. Compounding also works in reverse when you borrow money. Having to pay interest on interest deteriorates wealth just as quickly as earning interest on interest creates wealth.
– Liam Rutty –