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How Compound Interest Works – Everyone Should Know This!

How Compound Interest Works – Everyone Should Know This!

Way back in the dark ages, young people went to work for an employer, and in return for this work would be a ‘promise’ of a comfortable lifestyle at retirement age, principally in the form of a pension. This promise is what is also known as a defined benefit plan.

Nothing has changed since then, except nowadays, employees are more responsible with regards to putting money aside for retirement because, let’s face it, typical pension returns do not provide for enough of a retirement income in comparison to the lifestyle that people are used to living. These come in several forms, depending on where you live, such as Personal Retirement Savings Accounts (PRSA), 401(k) plans, or Individual Retirement Accounts (IRAs – not to be confused with the IRA).

This article isn’t here to dissect the mechanics of retirement planning, as for that you should seek independent financial advice. Instead, it’s here to permeate the concept of saving for retirement sooner rather than later.

There’s a quote from our old friend, Albert Einstein, who was quite a smart chap. When asked to name the greatest invention in human history, Einstein simply replied “compound interest“. Einstein was also coined with saying:

If you can’t explain it simply, you don’t understand it well enough.

So let’s put it simply, all of the benefits of saving early boil down to a simple principle which is called Compound Interest.

So what is Compound Interest?

We should start with looking at what the definition of Compound Interest is, from our good friends at Wikipedia:

Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously-accumulated interest.

Compound Interest takes place when the interest gained, on any amount of money, in turn creates interest for itself. It might sound far too simple to be real, but it does exist and also stands to show how those with wealth are able to maintain, grow, and continue to grow their wealth. The concept is the core of all finance.

Let’s take a look at an example that consists of three people. These three people experience the same annual return on their retirement funds:

  • Sarah, who invests €5,000 per annum, but only from age 25 to 35 (10 years)
  • Brian, who also invests €5,000 per annum, from age 35 to 65 (30 years)
  • and Carl, who also invests €5,000 per annum, from ages 25 to 65 (40 years)

Growth of Compound Interest Savings Example Chart

 

Obviously Carl should end up with the most at retirement as he has been saving for 30 and 10 years longer than Sarah and Brian, respectively. Notice though, how much more Carl has at retirement value, it’s the same total as Sarah and Brian combined.

What’s also interesting to see is that Sarah, who only saved for 10 years, has more money at retirement than Brian, who saved for 30 years!

How is that possible, it seems ridiculous!? That’s correct, Compound Interest…comprende?

The returns that Sarah is realising from her 10 years of investing are in essence snowballing, which means that Brian simply can’t keep up…even if he chooses to save for another 20 years.

What’s the moral of the story then?

It’s pretty simple, and it should be taught more/better in schools. The longer that anyone chooses to wait before retirement planning and saving, the greater the loss of benefits are of the power of compound interest.

How can I benefit from Compound Interest?

Firstly, talk with an independent financial adviser and get more details of how to maximise your retirement planning portfolio. You need to understand the ins and outs of what is required and how much you can afford to invest for long term gains. It’s also important to understand the concept of maximising Additional Voluntary Contributions (AVCs) as there are tax benefits, as well as long term compounding benefits, in doing so. The downside to Compound Interest is that it is a marathon, not a sprint, and you need to trust in the process.

S&P 500 Index over 90 yearsHere’s a pretty self-explanatory chart to show you the S&P 500 Index and it’s long term returns over the last 90 years. Over time, it does not fail. You need to factor that in with your marathon thought process in mind. This is one example, of many, the point being that a solidly diversified portfolio on the core index funds will give compound interest returns of roughly 7% year on year.

You can see more of these charts over at MacroTrends

 

There’s also handy calculator available at MoneyChimp to get a better understanding of your own potential investments over time which can be seen at the following link: Compound Interest Calculator

Enjoy retirement 🙂

PS: Here’s a cool story on how a Janitor left behind an $8,000,000 Secret Fortune…you might notice a common theme (summary below).

Like the majority of those in the top 1% of wealth, Ronald was stealthy about it, keeping his money a secret from even his own children and friends.

He relied on an intelligently constructed, diversified, representative list of common stocks that were arranged in such the inevitable losses were swamped by the growth and income of the other holdings.

Ronald wanted ownership, and to live off the money his assets pumped out regardless of subsequent stock performance. He is called a simple-living Vermonter who enjoyed “Playing the stock market”.

Like many members of the top 1% or 2% of net worth who amass much larger-than-average estates, Read appears to have been motivated, in part, by altruism.

 

What are your thoughts on Compound Interest? Please share comments below, and feel free to share this article with anyone you think could benefit from it.

 

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