This article discusses the incredible power of compound interest. We take a look had how different investing scenarios affect your wealth’s growth and the most important factors for compounding. This article may contain affiliate links, for more information please see my disclosure policy.
If you have been hanging around the personal finance community you have probably heard some version of: “The best time to start investing is 5 years ago, the next best time is today.”
Even modest investments can grow to wealthy sums given enough time. Because of the compounding nature of investments, time is the greatest factor that determines how your investments grow.
I believe the best way to really see the power of compounding is to look at a different investment scenarios.
One Time Contribution
Let’s pretend Ashley is 20-year-old college student. Ashley has worked hard and gotten scholarships to pay for her tuition, and has a part time job to cover her living expenses. One day after enjoying her mac and cheese from Noodles she sees a survey at the bottom of her receipt that she can fill out to possibly win $5,000.
Three months later she has totally forgotten about the mac and cheese and the survey until she gets a call telling her she won and that she needs to fill out some tax paper work and then they would mail her a check. Side note: this actually happened to one of my friends, no idea what she actually did with the money, but who knew people actually won these contests!
Ashley takes her winnings and adds a little extra to max out her Roth IRA for the year with $5500. She invests in an index fund with an average return of 8%.
She promptly forgets about the account and doesn’t add anymore money to it until she is 65 and ready to retire.
Ashley is shocked that her original $5500 investment had grown to over $162,000. The chart shows how the earnings quickly outweigh her initial investment.
Now, let’s pretend the Ashley keeps eating mac and cheese and keeps winning survey contests (or maybe she gets a decent paying job in her field, makes a budget, lives modestly with roommates and an old car, and puts part of her salary into retirement savings)
Each year she diligently maxes out her Roth IRA contribution of $5500 and invests it in an index fund earning 8% interest.
This time when she is ready to retire at 65, she has over $2,125,000. Over the 45 years of her career she put away a total $247,500 of her own money. The chart shows how much she was able to earn, and how her interest far outpaces her investment.
The Time Factor
Procrastinating is human nature. It is easy to put off investing because you “need the money now” or “you’ll save extra next year”.
Every year that you put off investing, you are costing yourself one year from the end of the chart. The longer you put off investing, the more you will have to contribute (or the longer you will have to work) to retire with the same amount of money.
To illustrate the cost of waiting, let’s consider Ashley’s friends, Marco and Sarah.
Marco graduates college and it takes him a year or two to get comfortable with his budget and paying down student loans. At the age of 25 he reads this article and decides to make investing a priority and starts maxing out his Roth IRA at $5500 per year.
Sarah continues on to graduate school and feels as though she has no money to contribute to retirement. When she starts working, she doesn’t want to invest until after she pays off all of her loans. At the age of 35 her loans are paid off and she wants to dedicate all the money she was putting towards her loans towards her retirement. She maxes out her Roth IRA and puts $5500 in her 401Kfor a total contribution of $11000 per year.
The chart below shows how each of their investments grow.
Ultimately, Ashley contributed $247,500 over 45 years, Marco contributed $220,000 over 40 years, and Sarah contributed $330,000 over 30 years. Even though Sarah contributed the most, she retires with the smallest sum of $1.25 million. Marco was able to save a nice sum of $1.42 million. And Ashley, whose money had the longest to grow, retires with $2.13 million.
Start Early. The longer your money has to grow, the more you can take advantage of compounding interest. As you saw in Ashley’s case, her money had the longest to grow and she retires with the largest value.
The next best thing to starting early is starting now. Marco was still able to save up a good amount for retirement by starting when he could. If you haven’t started investing yet, there is no need to be overly hard on yourself, instead, go open an IRA and start now!
Make Regular Contributions. Life happens and making regular investments can be hard but it is worth it in the long run. Although Ashley’s first contribution did grow greatly, with regular contributions she was able to build wealth sufficient to support her retirement.
Question for you: What age did you start investing?
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