People often associate interest with debt… interest payments on a credit card, or mortgage, etc. But interest can also work in your favor, in a very, very powerful way.
Albert Einstein said, “compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
What is compounding interest?
When you keep your money in a high interest bank savings account, or invested in assets like dividend paying stocks, you get paid on your principle passively at a regular frequency. When these earnings are added to your original principal balance over multiple cycles, the interest starts to compound. Not only are you getting interest on your initial investment, but are getting interest on top of interest — over the course of time, this creates an exponential snowball effect on growth.
To see this powerful effect, let’s look into the numbers and a couple of charts to show the exponential growth curve.
Let’s take a person who saves $400 a month or approx. $5000 a year. If that person makes a $5000 annual contribution to a tax free retirement account, and earns 7% annual growth, they will become a millionaire by doing nothing else, in exactly 40 years.
The effects of compounding interest magnify exponentially as you go further along in time. For instance, the example above it takes you 40 years to make your first million, but then only 9 years to make your 2nd million. The numbers look like this:
- $5,000 yearly contribution x 7% x 40 years (compounding) = $1,068,047
- $5,000 yearly contribution x 7% x 49 years (compounding) = $2,027,644
Better yet, it takes just 6 years to make your 3rd million, and just 4 years to make your 4th million.
- $5,000 yearly contribution x 7% x 55 years (compounding) = $3,081,217
- $5,000 yearly contribution x 7% x 59 years (compounding) = $4,060,644
See how powerful the time variable is to the compounding interest equation? 40 years to make the first million, but only 4 years to make the 4th million.
But what if you had 75 years to invest? Those $5,000 annual contributions would swell to $12,142,000. If you were able to achieve 9% annualized returns instead of 7%, it would grow to a staggering $38,767,000.
Remember $38,000,000 account is created by investing just $5,000 a year passively at a 9% growth rate. Just look at how dramatic the exponential effects of getting a 9% vs 7% annual return.
Is a 9% annual return realistic?
The 25-year average annualized return for the S&P 500 from1994 through 2018 was 8.52%. Assuming you invested in an S&P 500 index fund and never withdrew money, you’d have enjoyed average returns of 8.52% per year. And while the market has enjoyed good returns historically, what about the future? Investing legend Warren Buffett predicted that the long-term returns of the U.S. stock market in the 21st century “will witness further gains, almost certain to be substantial.”.
There are 3 primary factors that have driven the stock market higher over time 1.) growing population, 2.) increasingly efficient labor, 3.) capitalism as a system. While historical performance does not guarantee future results, it is probable that in the years ahead the stock market will continue to grow and has a good chance to outperform the last century.
P.s. fun fact — At 8.52% annual growth, you will double your money about every 8.45 years.
Why does everyone not prioritize this?
The numbers don’t lie, and the exponential effects are mind blowing. So why is everyone not talking about this at the water cooler? Here is the problem…you’ve probably already thought of this yourself, but human lives are only 78 years on average, and the peak spending years are 42 – 48. After that, on average most people start downsizing lifestyles and spending less.
Also, many people today aspire to have much more than $1m and don’t want to wait 40 years to get there. Nor do they have 50 years to wait to be a multi-millionaire! This is why, as alluring as these numbers are, in reality most people have trouble being disciplined savers and instead decide to spend and live better today.
But here is the trick — you need to accelerate timetables by contributing more each year. Here are the ways you can save and contribute more.
- Don’t give in to inflationary lifestyles (aka lifestyle creep) – this is a sure way to spend less and invest more.
- Maximize any employer matched 401k plan – this is essentially free money, which will in some cases double your yearly contributions
- Setup a SEP or self employed 401k with high limits if you are self employed – you can contribute even more money annually through these vehicles than with a typical ROTH IRA accounts.
- Get 9% instead of 7% returns annual returns – historically you’d be able to achieve this by weighting your investments towards stocks, and in particular, small cap stocks.
- Supercharge your savings by earning more through entrepreneurship, employee stock options, real estate, side hustles, and/or increased wages
What if I don’t have 40 years to invest?
One thing to remember is, with the current advances in science and medicine, many people are predicting that 120 years of age will be in range for a lifespan of anyone reading this. That means if you are 35, another 35 years may only put you just past mid life. And if not for you, how about creating generational wealth for your heirs or you favorite charity?
There is a case to be made for just about everyone to save and invest a little more, no matter where they are in life.
Here are a few important ingredients to ensure your long term success on the journey of investing for compounding interest:
- Get started as early as possible – compounding interest favors those who start early, which is why it’s important to start now if you have not. It’s never too late to start — or to early.
- Pay yourself first – this means, make your contribution as soon as you get paid, not at the end of the month if you have money leftover.
- Keep fees close to zero – you can do this by investing in a low fee S&P 500 index fund such as through Vangaurd. Fees are a killer in long term performance.
- Make it automatic – setup your investments and contributions automatically. If you have to do it manually, it is more difficult to remain consistent.
- Make it tax free – use a vehicle like a ROTH IRA for retirement or talk to your tax professional.
- Reinvest earnings and dividends (automatically) – make sure your investment is automatically set to reinvest your dividends.
- Don’t make a mistake – the #1 mistake is having to take money out of this account at the wrong time. Set aside an emergency fund and learn about market cycles to take the emotion out of this investment.
The exponential curve of compounding interest was something that even Einstein got excited about, so here it is again.
Don’t be detoured in the early, slow years — rather focus on the math and long term trajectory. Compounding interest is the reason the rich get richer, but the good news is, everyone can participate and reap the gains
For someone to get from $1 to $1,000,000 in net wealth, can take a lifetime of disciplined saving. But for someone worth $10m to make that same one million? That can take just 1 year of being invested in a passive index fund like the S&P 500 ($10m +10% = $11m). That is why the rich get richer, even when they are not trying.
Pro-tip: if you are a parent reading this, you can get this started for your kid today. There are various ways you can help you child “earn” some income — even a baby. Have them model for an advertisement for your company, and pay them their first $5,000 contribution. Get this started for them when they are young and let them effects of compounding interest pay them throughout their lifetime.