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Never Underestimate The Power of Compound Interest

Investing, Saving10 Comments

Never Underestimate The Power of Compound Interest

One common way to build wealth is to spend less than you earn and invest or save the difference. This is like the basics of personal finance. In order to make your savings grow faster, you have two options available: increase your income or increase your savings. Unfortunately, increasing your income is not something you can always easily do (either by asking for a raise, or maybe you could start a side hustle?), but saving more is easily attainable.

Most of the personal finance books I’ve read this last few months emphasizes on this a lot. In fact, in Stanley and Danko’s The Millionaire Next Door, they clearly state that it’s not a high income that leads to building wealth but saving (obviously, earning a high income helps with this a lot).

This is why the importance of compound interest has become more crucial than ever before. If you are in your 20s, you might believe (like I did) that investing or saving for retirement is something that would be better handled *later* but this is without taking into account the most crucial factor — Time. Increasing your income or saving more *can* be done later on in life, but time is limited in its essence and you won’t be able to catch up easily for all these years where you could have quickly and effectively stashed some money for your rainy days! Time is on your side now, and you should definitively know what’s compound interest to understand why now is the time to start saving for retirement.

What is compound interest

By definition, “Compound Interest (or Compounding Interest) is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.”

This means that interest compounds over itself. As an example, with a savings account which has an annual interest rate of 3% and a balance of $2,000, at the end of the first year you would have $2,060. But the next year this would be $2,121.8 instead of $2,120 because you earned interest over your interest. The interest rate is applied to the amount of your previous balance, which in turn includes your previously gained interest.

This is the power of compounding and even if it’s really basic, it’s so powerful at the same time. This is one of the key to build wealth because even with low interest rates, if you’re patient enough time is your best friend. Don’t get me wrong here, you’re not gonna get rich with compounding in the short-term, you need to keep focused on your long-term goal aka retirement for most of us! When you take this concept and apply it over the course of a long-term, such as 10 or 20 years, results are completely different (and much better).

The younger you start, the more time compounding has to work in your favor.Click To Tweet

Compound Interest can work FOR you

Compound interest can be used to your advantage. Remember that if you withdraw the money deposited in an investment account early on, in most cases the interest earned will not have changed significantly. However, if you let your investment grow long-enough, the interest you earn is allowed to compound over itself many times and can then lead to a very lucrative amount in the end. This is why Time is the main aspect of compound interest and why you should start investing as early as possible to fully benefit from it.

As an example the following chart details a $500 per month investment over a fifteen year period for three different persons (all with a 5% return on investment compounded annually for the sake of simplicity). Person A contributed from age 20 to 35 and then stopped contributing but did not touch the money until age 65. Person B did the same but from age 35 to 50 and Person C from age 50 to 65.

Never Underestimate The Power of Compound Interest

Even if these three different person invested the same amount ($90,000), the results are totally different. This is because Person A had Time with him and has let its investment grow from age 35 to 65 (from $129k to a whooping $559k!). Remember that this was for a quick example where someone *only* contributed for 15 years and for a low $500 per month. Guess what happens when you increase your length of contributions and also the amount per month? The final amount would be sooo much more as all of this is exponential!

If you plan to retire one day, you should be amazed by such differences. So start as early as you can if you have not already started! And do not withdraw, let the magic of compounding happens!

But also AGAINST you

Remember that this is the exact same concept that credit card companies use to their advantage when you see advertised seemingly low rates. In short, this is because for them interests are calculated daily and not on an annual basis. What this means is that you will pay a way higher percentage of your original amount than what’s advertised if you don’t pay your balance in full each month.

For the sake of simplicity, let’s say that your average daily balance on your credit card was exactly $2,000 for the entire year. With a credit card with a 20% APR, if interests were charged just once at the end of the year, you’d pay $2,400 total (with $400 being interests). But since your interest is compounding, the interest gets added into your balance, and then you pay interest on your interests. In that specific case you should actually pay for more than $2,442 for an effective interest rate of 22.13%!

As a result, a large portion of your monthly payments will actually begin paying off the interest on your balance rather than just focusing on your total balance. This is why so many people find it nearly impossible to get out of debt if they do not plan ahead or if they do not have an emergency fund. The takeaway here is quite obvious: never carry a balance you can’t pay on your credit card and always pay it off in full each month!

Take action now

Now that you have a grasp of how compounding works, you can make it work for you in just a few easy steps:

Never Underestimate The Power of Compound Interest

  1. Start as early as possible

Remember that the younger you start, the more time compounding has to work in your favor. Also remember that someone once said:

“The best time to invest was yesterday. The second best time is right now!”

Don’t let yourself or other people tell you that you can start saving later. Even if it’s only for a few dollars each paycheck, the costs of delaying your investment are enormous! Also, don’t leave your money on a no-interest checking account, make use of online banks to have at least some interests there too (such as Tangerine for Canadians).

  1. Automate everything

Stay disciplined and automate your finances! Direct transfer as soon as your paycheck hits your account and you will not even know it was here in the first place. Use extra money like bonuses, tax refunds, or unexpected windfalls to boost your fund.

Make saving for retirement a priority. Do whatever it takes to maximize your contributions:

  • Max out your RRSP or 401(k) contributions if possible
  • Contribute regularly to your TFSA or Roth IRA (which takes less than 15 minutes to open with Wealthsimple)
  • Maybe also start out a savings account for your kids (RESP or 529)?

The key is to automate and contribute regularly!

  1. Give it time

Do not feel tempted to touch the money. Compounding only works if you give it time. Be patient! Most of the magic of compounding returns comes later. This is also known as the snowball effect.

Compound interest is very powerful when you understand it. It’s an old concept but such an important one to know. If you have not already take action now and start saving for the future!

– Vincent

Have you taken advantage of compound interest early on? Do you think you should have started earlier (I surely do)?

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  • Avatar for Finance For Geek
    David
    Mar 16, 2017 at 8:20 PM

    Great post! People seriously don’t understand the basics of compound interest, and how it helps them. If you max out an IRA for 40 years, you have more than $1 million if you get a 7% real return — yet most people can’t be bothered to even attempt investing the $5,500.

    • Avatar for Finance For Geek
      Finance For Geek
      Mar 16, 2017 at 8:35 PM

      Thanks David! Yes indeed a lot of people still don’t get it easily, but I’m kind of ashamed to say that it’s not been that long that I’m taking advantage of this too 🙂 Better late than never!

  • Avatar for Finance For Geek
    Courtney @YourAverageDough
    Mar 16, 2017 at 10:03 PM

    I just wrote a post about compounding interest 2 days ago myself!

    I really enjoyed reading this, as it was nice to see another perspective on the topic. I truly do believe many people underestimate compounding as they are so short-sighted.

    I, like you, think I should have started earlier. I am still in my 20s, but wish I started saving back at least in college, if not before!

  • Avatar for Finance For Geek
    The Financial Tech
    Mar 17, 2017 at 8:55 AM

    Yeah I’ve underestimated the power of compound interest last year and I should have let my money growth instead of trying to chasing some stocks.

  • Avatar for Finance For Geek
    The Luxe Strategist
    Apr 03, 2017 at 1:59 PM

    Hey! Compound interest is so important and I wish someone had explained it to me when I was younger. I think if someone had shown me a chart of how much money they made without doing much I would have felt more compelled to invest. With that said, I didn’t start saving much until I was 26 or so, but I’m in the 6-figure net worth range now because I’ve been playing catch-up in the past few years. It’s really encouraging to see your net worth grow–I look at it every day, because I’m a crazy person. I hope to do a post soon on why investing is important, because you kind of can’t afford not to, if you want any results.

    • Avatar for Finance For Geek
      Finance For Geek
      Apr 03, 2017 at 6:39 PM

      Hey there. I totally agree with you on the fact that I wish I had understood it much earlier in life also! 26 still is ok because for me I only really started when I was 28 🙂 I’m also kind of addicted and definitely check my net worth way too often.

  • Avatar for Finance For Geek
    Joe @ Average Joe Finance
    Aug 09, 2017 at 8:55 PM

    Great point that it’s not high income that leads to wealth but saving. When you shift your mindset to thinking of money as an asset, it becomes easier to focus on building wealth. If compounding is good enough for Warren Buffett, then it should be good enough for the rest of us. I love compounding because it makes it possible to save even small amounts and have them grow into substantial nest eggs over time.

    • Avatar for Finance For Geek
      Finance For Geek
      Aug 17, 2017 at 2:42 PM

      Yes and yes! I guess some people haven’t learned to make money work for them and not work for money. I know a few people that were not high income earner for their whole life, yet they successfully managed to build a golden retirement fund on their own with (a lot of) discipline and regular small savings!

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