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The Power of Compound Interest
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.” - Albert Einstein
How dramatic is the effect of compounding?
For finances, and most other objective measured, the value of compounding grows in logarithmic fashion. This means that as you move along the horizontal (x) axis, the growth on the vertical (y) axis grows exponentially. More simply put, the line curves upwards (or downwards if in debt) instead of increasing in a straight line -see below.
Frequently, in the personal finance community, we use money on the horizontal (x) axis, and net worth on the vertical (y) axis as follows:
Examples of the effects of compound interest using $10,000 initially and never adding another dime!
After 10 years, your initial $10,000 (assuming you added nothing else), grows to only $19,990. Not bad, but this will not get you rich.
After 20 years, your initial $10,000 (again assuming you add nothing), grows to $43, 157. Again, not too bad considering you never added another dime - which is typically very unrealistic for those interested in saving and investing.
Fast forward to the 50 years mark, your initial $10,000 investment turned into a whopping $434,274. Again, this does not adjust for inflation and just shows you what your initial dollar amount will potentially turn into after 50 years of passive index fund investing.
Initial investment of $10,000 plus adding another $500/yr to your investment
You may feel somewhat underwhelmed after that first example. That is fine. The power of compounding is quite dramatic, however some folks argue and become upset when they hear about 50 plus years of investing. It might just be too far out for most people to imagine and remain motivated on the path to F.I.
This is where demonstrating the power of saving plus compound interest comes into play.
Take our initial investment of $10,000, use the same parameters of hypothetical growth at 8% compounded annually, and add $500 a year.
This time it only takes 43 years to cross the $400,000 mark. At the end of 50 years, your initial investment of $10,000 plus an additional $500/yr, compounded at 8% annually, turns into $720,000.
Initial investment of $10,000 plus an additional $5,000/yr in an IRA
Now what if you simply take your initial investment of $10,000, and add $5,000 per year to an IRA, compounded annually at 8%. Essentially this would be nearly maxing out an IRA every year ($6,000 contribution limit as of 2020).
Following this process of $10,000 initial investment, plus $5,000 contribution annually to an IRA, compounded at a hypothetical rate of 8% annually - you would be a millionaire in 36 years with your investments growing to $1,078,364.
At the 50 year mark, you'd have potentially $3.3 million in the bank. Not too shabby.
There is significant potential waiting for you in the form of "compound interest"
As you can see, compound interest takes time to reveal its' magic. The earlier you start, the longer you have for compound interest to work in dramatic fashion.
When evaluating the role of compound interest most folks refer to the rule of 72. The rule of 72 helps you learn how long it will take to double your initial investment. You discover this by dividing 72 by your expected annual interest rate (8% in our example).
The Rule: 72 / expected annual interest rate = years until initial investment doubles.
In our example: 72/8 = 10.3 years. In other words, every 10 years our money would double.
How do I make compounding more powerful?
As you can see, each of our models demonstrates-after a hypothetical return-a "hockey stick" growth curve. This means your money compounds and grows exponentially upward instead of a straight line.
Of course, this does not happen consistently. Here is a caveat: Actual stock market returns look nothing like a smooth line the way our model shows. It takes many scary nosedives in a few months to high altitude climbs over many years. These fluctuations occur due to many reasons such as investor behavior, consumer sentiment, inflation, pricing, GDP, etc. Many factors determine market returns.
However, according to over 200 years worth of data, the average return of the stock market is in the 8-10% range. Remember, this is just an average. Do not expect these returns on a reliable and consistent basis. Some years will be higher, and some years will be much, much lower. Overall, unless America "goes out of business", you are likely to see a positive return with longer time horizons of 20 years or more.
How To Increase the Power of Compound Interest
There is a very simple, yet often overlooked method of increasing the power of compound interest. How? START WITH A HIGHER INITIAL INVESTMENT.
To illustrate my point, say you start with an initial investment of $100,000, instead of $10,000. Do not add another dime to that $100,000. Ever.
In 50 years, after an 8% return compounded annually, you'd see your initial investment grow to...
This is approximately $1.4 million more than what you would have compared to if you initially invested $10,000 plus $5,000 a year compounded at 8%.
To illustrate this point further, in the model representing a $10,000 initial investment plus $5,000 annually, you will have contributed a total of $260,000 of capital with a final worth of $3.3 million.
By starting with a greater initial investment, not only will you be worth $1.4 million more - at a total of $4.7 million - but you will contribute $160,000 less of your own capital.
The power of compound interest is one of the primary motivators that keeps me steady on the path to F.I.
Consider visiting a compound interest calculator and plugging in your own numbers.
Remember, our models and examples are completely hypothetical and do not represent real returns, nor are they adjusted for inflation. In no way is this a guarantee of returns. Please seek guidance from a financial professional, of which I am not.
Still, the point remains. The dramatic effects of compound interest are on display.
The ideal recipe would be to start with a big lump sum as soon as possible. However, if you are unable to do this, the next best method would simply be to start as soon as possible.
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Further, take a look at our favorite resources that built the foundation for our awareness of financial independence, frugality, and investing.
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