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.
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:
- 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).
- 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!
- 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!