You know that familiar saying “time is money”?
Well, turns out, it is actually true.
The topic for today has also been referenced as the 8th Wonder of the World by Albert Einstein, in his famous quote “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”
While he may not have been talking about your Investment Assets or Retirement Plan, he may just be right.
With the proper understanding of how it works, how to make it work for you, and understand that time in the game is arguably the most important when it comes to your finances, you may just be able to get your finances back on track.
Since we will be discussing investment related topics today, please let this disclaimer remind you that before making any investment decisions, you should consult with a financial professional. This information is general in nature, and IS NOT FINANCIAL ADVICE.
With that out of the way, let’s dive in!
What is Compounding Interest?
To paint a simple picture, think of those old cartoons where you see a snowball rolling down a hill.
As it makes its way down the slope, what once was a small pile of snow being pushed by a child turns into an out-of-control missile that can knock down anything in its path.
Depending on what’s in the path can make all the difference as to whether or not it is a force used for your benefit, or for your demise.
This is true in the sense of the compounding interest of your investments and assets you own (the good!), versus the debts and liabilities you owe (the sometimes really bad!) when it comes to your financial picture. We’ll come back to that in just a second.
To keep the exercise simple, let’s assume we have $100 that is going to grow at 5% for each year for three years.
In Year 1, $100 will grow 5% (or $5), and be $105 at the end of that year.
In Year 2, we now start with $105, and this now grows by 5% (or $5.25), and will be $110.25 at the end of that year.
The same is true for Year 3, but now our 5% growth will be about $5.50 and we will have $115.75.
Just like that snowball, it will add a little bit more snow each time it makes a full rotation, because the surface is just a little bit bigger every time it completely rolls around.
How does Compounding Interest make people wealthy?
There are a couple of factors at play when it comes to using Compounding Interest to build wealth. Time and discipline.
We’re going to start with the hard one first, discipline.
If we think back to that snowball yet again, what happens if you stop pushing the snowball before it gets large enough? You’ve probably experienced this at some point in time if you’re from the Midwest like I am, but long story short… you’re probably going to end up with a lumpy ball of snow that really isn’t what you’d hoped for.
The same is true for if we were to let something disturb the snowball when it just began rolling. It might break, and we’d have to start over, ultimately having to spend more time and energy getting it to the point where it would finally roll down the hill.
This also happens when it comes to saving and investing.
Reacting to a down stock market, raiding your savings, or not saving enough can have dramatic impacts on how well compounding interest can work for you.
Sticking to a plan, knowing what you need to save in order to create enough momentum with your dollars, and properly planning for Emergency situations can help you have better chances of reaping the rewards of Compounding Interest.
If we go back to our math example, but this time use a number like $250,000 (the average balance of retirement savings for those Age 55 to 64 according to USA Today as of May 8th, 2023), the effect becomes much more dramatic than if we only had $100.
In Year 1, $250,000 will grow 5% (or $12,500), and be $262,500.
Year 2, you’d have an ending balance of $275,625, an increase of $13,125.
Those are not small numbers!
And while the stock market doesn’t increase quite so predictably in a given year, the historical averages do paint a picture of long-term appreciation similar to our example.
In fact, according to many publications, the average return of the S&P 500 index is right around 10% annually since 1926. (This is not investment advice, you should consult a financial professional to discuss your individual situation prior to making any investment decisions).
If we stretched this out over a period of 40 years of a Career, and started back to our $100 example at 10% interest per year, you’d have $4,525! That’s without ever investing another dollar, but just letting time and discipline do its thing.
But… how? How did that $100 turn into such a large number?
You can see a breakdown of those 40 years and the interest credited each year. Notice anything about the amount of interest at the beginning versus at the end?
Chart above assumes a 10% Growth Rate occuring every year. The first 10 years show how $100 would grow each year, while the 20,30,40 year marks are showing what cumulative growth looks like as time goes on. For instance, Year 20 includes Years 11-19 of uninterrupted compounding of an intial $100 investment.
How does Compounding Interest make people wealthy?
When it comes to wealth creation, there are a few things I want to put out there.
- 1) Every asset class (stocks, bonds, cash, real estate) have their own set of risks, rewards, and reasons why they are popular.
Real Estate is the first one I am going to pick on. It’s not because it’s bad, but more because it is one of the few things most Americans let compound. You don’t need a home to be wealthy, but many people buy a house and live in it their whole life, letting compounding do its thing. We’ve all heard those stories of the people who bought a home for dirt cheap decades ago, and now are sitting on a ton of money.
In reality, the average price increase (or rate of return on home purchase price) is only about half of that the stock market sees over a long period of time, about 4.3% from 1991 to 2023 according to the Federal Housing Finance Agency (FHFA).
Stocks are the next one I am going to pick on for just a bit. They typically get the headlines of making people extremely wealthy, but the average investor doesn’t outperform the S&P 500 on an annual basis. In fact, even most of the best investors and Hedge Funds fail to beat the average 10% return mentioned earlier in a given year.
When it comes to Compounding Interest, your risk, time horizon (how long you will be invested for), income and liquidity needs, and goals will all come into play when deciding what your target rate of return should be.
A quick an easy rule with Compounding Interest is to take the number 72, and divide it by your rate of return. This is called “The Rule of 72”, and the answer to the math equation will tell you about how fast your money will double in value.
If you go back to our example of the $100 at 10%, that would be 72/10, giving us 7.2 years. Looking back at our schedule of interest you’ll we reach $200 somewhere between Year 8 and 9.
While this breaks the rule, it is a mathematical rounding error due to the simple calculation making it easier to visualize the payments on an annual basis rather than compounding monthly. If you’d like to see the actual math, shoot me a message! 😊
- 2) Will it be for good or bad when it comes to your finances?
The math will do the rest of the explanation for this piece!
S&P 500 Growth/Interest Rate of 10% would take 7.2 Years to double.
A Credit Card with Interest Rate of 20% would take 3.6 Years to double.
Interest on a Student Loan or Mortgage isn’t always a bad thing, but knowing what your plan is going to need, making smart choices about how you use debt, and ultimately avoid debts like the plague if they are going to grow faster than your investments.
- 3) Compounding Interest can be the answer to achieving Financial Independence.
Let’s use a little bigger of a number to illustrate this final piece, like $1,000,000. Your expenses will increase at the long-term inflation assumption of 3% each year.
For this last example, it is extremely simple math. Results may vary, and timing of expenses would likely impact the actual result to be a slightly lower number.
If we have a growth rate of… let’s say… 7%, and you need $40,000 per year to live off of after your Social Security, your $1,000,000 in Year 1 will grow to be $1,070,000.
If you spend $40,000 of that (including any taxes of course), you’d have $1,030,000 to start Year 2 with.
You’ll now have the same purchasing power as your $1,000,000 (because 3% inflation would mean $1,030,000 is only worth $1,000,000 this year) last year, and the same process plays out.
Year 2 growth of 7% on your $1,030,000 will bring you to $1,102,100 and you’ll spend a little more due to inflation this year ($41,200), leaving you with $1,060,900 to begin Year 3.
The compounding has slowed due to the fact we are now using some of the growth to fund your living expenses, but the interest generated is now helping preserve your purchasing power as you go through retirement… and your money is keeping up with inflation.
- 1) Compounding Interest can be used for your benefit and ultimately help you achieve Financial Independence if you let it work for you, rather than against you.
- 2) Time and discipline are keys to success if you are playing the long game, rather than trying to “win the lottery” or “get rich quick”. Your odds of winning the long game are MUCH BETTER than winning the lottery, too!
- 3) The longer you save and let your money compound, the lower the amount you need to save to end with a similar result. Knowing your expenses, how long you can be invested, and creating habits to systematically save will help you benefit from Compounding Interest.
Not sure where to start, or just really hate math and spreadsheets? Schedule an initial consultation with us and we will see how we can help!
If we can’t we promise to point you in the direction of someone who can.