Get to grips with compound interest and start saving
You don't have to be wealthy to start investing. (Pixabay)
Although we often hear about the “wonders” of compound interest, many people don’t know what it actually means, and they miss out on its benefits.
Two quotes are attributed to Albert Einstein regarding compound interest. It is said that Einstein referred to compound interest as “the greatest mathematical discovery of all time,” and on another occasion he claimed that it was the “eighth wonder of the world.” Although we don’t know if these quotes are accurate, there is definitely something magical about compound interest.
What is it?
Compound interest is the ability of an asset to generate earnings, which are then reinvested to generate their own income. In other words, the term “compounding” refers to generating earnings from previous earnings.
The magic of compound interest transforms your hardearned money into a very efficient tool for building long-term capital.
For compounding to really work, however, it is necessary to reinvest all earnings over time. When an investor gives more time to his investments, he is more likely to optimize the income potential of the original sum.
For example, if an investor had $5,000 in an account that paid 5 percent annually in simple interest for five years, he would earn $250 a year. This would generate a total of $1,250 in interest. However, the same $5,000 investment paying 5% in compound interest will earn more.
If the money is reinvested and compounded annually for five years, it would produce a total of $1,381.41 in interest. This is because when the investor earns interest on his interest, the yield – an average of 5.52% per year – is higher than the actual interest rate at which he initially invested. This difference of 0.52% a year may seem insignificant, but multiplied out over 20 to 30 years it’s huge.
The earlier the better
When an investor starts investing at a younger age, he will benefit far more from compounding. To understand this further, let’s take the case of two investors, named Penina and Joe, who are both the same age.
When Penina was 25, she invested $15,000 at an interest rate of 5.5%, which was compounded annually. By the time Penina reached 50, she had $57,200 in her bank account. Joe, on the other hand, did not start investing until he reached the age of 35. At that time, he invested $15,000 at the same interest rate of 5.5% compounded annually. By the time Joe reached 50, he had just $33,487 in his bank account.
Both Penina and Joe are 50 years old, and both invested the same amount of money ($15,000) at the same rate of interest (5.5%). However, Penina had $23,713 ($57,200 compared to $33,487) more in her savings account than Joe, even though he invested the same amount of money! By giving her investment more time to grow, Penina earned a total of $42,200 in interest while Joe earned only $18,487.
The above example clearly demonstrates the positive benefits of compound interest. Taking it a step further, imagine that Penina, who invested $15,000 at the age of 25, also adds an extra $2,000 a year to her account, where everything is invested at a rate of 5.5%. If she were to continue this disciplined investment approach until retirement (at the age of 65), she would end up with over $413,000. And if Penina were to add some risk to her investment profile in the hope of getting an even higher return, her nest egg at retirement could grow even more substantially.
The cost of waiting
As mentioned earlier, the two essential aspects for compounding to work are reinvesting the earnings and time. Each year that goes by without any investment will therefore affect your retirement. If you have 30 to 40 years until retirement, every year that you forgo saving or investing money today may subtract between one to five years from your retirement.
You don’t have to be wealthy to start investing. If you start saving early and make disciplined contributions, you can retire with a very large nest egg.
By Aaron Katsman