Discovering the Power of Compound Interest

The reader stories I've been featuring on Sunday for the past three months seem to be a resounding success. Instead of being the only one to read your triumphs and failures, the rest of the GRS community can share them, too. I have no plans to expand this feature beyond Sunday, but I'm making an exception today. This short post from Jess Rundell fits with April's “financial literacy” theme, and I think it's worth sharing.

Since you always stress the magical properties of compound interest on your blog, I wanted to tell you a story about how I have learned the value of compound interest for myself. Intellectually, I've been aware of compound interest, and the fact that I should begin to save for retirement as young as possible, but after today I know this to be true.

I'm 21 and a final-year undergraduate university student. Although I've never had a “proper” job, I've had a few part-time jobs, and for 6 months when I was working in a call centre last year, I joined the pension scheme, although most of my friends thought it was a bit weird.

After I left the job to focus on my studies, I didn't think much of the pension fund, and I stopped paying into it because I'm extremely poor without any income except for my loans. But today I got my first yearly statement from the company managing the pension.

Apparently, I paid around £100 into the account, and my employer paid around £200 into it (free money!). The statement informs me that, if I pay no more money into my account, the approximate amount I'll have at age 65 will be worth nearly £20,000, or £725 income a year (in today's prices, so taking account of inflation).

Now, it does stress that this depends heavily on various factors that I don't really understand. But at face value, this essentially means that I turned £100 into £20,000 simply by filling in a form allowing the company to take it from my paycheque pre-tax. I didn't miss the money — less than £20 a month, the equivalent of two paperbacks or going for lunch with a friend — and it wasn't terribly onerous filling in the form.

I graduate in June, and as soon as I start working, I'll be resuming payments into my scheme. It's amazing how much motivation looking at my statement today provided. I feel like I understand compound interest for the first time ever.

J.D.'s note: It's always interesting what makes a concept “click” for one person. For Jess, seeing projected returns on a small retirement investment made him see the light about compound interest. I clued into compounding when I saw the cost of waiting one year…

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Nicole
Nicole

Good for you! Yesterday I was playing with the mortgage calculator and what paying extra at different points in the loan did to the final payoff date. It’s pretty crazy. Of course, we might be better off putting that money in the stock market, but any kind of investment beats buying unnecessary stuff. It’s nice when you can skim off the top early and not worry about decreasing standard of living while you’re just getting started. It does kind of make me wish we hadn’t wasted 5-6 years in graduate school, but money isn’t everything and we’ll turn out ok… Read more »

David
David

When I first started graduate school I was paid in lump sums (through a fellowship). I was coming straight from college and used to living in a dorm on practically no income. I took advantage of this and saved about $12,000 the first few years. Today, 5 years later, that initial investment is worth over $40,000, and I am so glad I invested that money early. On top of that, like Jess, it makes me really excited to continue to invest. Starting in graduate school is early to some, but it makes me wish I had started investing pocket money… Read more »

cmadler
cmadler

Unlikely. Getting from £300 to £20,000 in 44 years implies a 10% annual return, net of inflation. I don’t have historical UK inflation figures, but in the US it’s run at about 3%-4%/year for the last hundred years, which means that to get that kind of result, you need about a 13.5% return after any investing fees. Which means you probably need at least 14% gross return. It’s possible – no one knows what the market will do tomorrow – but it strikes me as unlikely enough that I definitely wouldn’t plan based on that!

Budgeting in the Fun Stuff
Budgeting in the Fun Stuff

Compund interest is the driving factor of our fiscal lives! I started contributing maximum matching to my 401k when I started my job in 2005…a measly 6% of my paycheck plus the company match has turned into $17,000 in 4 1/2 years (would have been better if I raised my contributions in 2008, but I opened a Roth IRA and wanted it fully funded instead). 2 1/2 years of fully funding a Roth IRA has turned into $16,000 as well. According to financial calculators, an average rate of return of 8% a year will yield nearly $1.75 million by the… Read more »

Adam
Adam

As well all know now, and should have known before. Waiting 1 year, could be a bad move, or a it could be a great move. It all depends on the market. Compound interest isn’t going to do you any good if the market falls 5% that year. You may have had $10,000 in a retirement account at 25, and if you’re 30 now, you probably don’t have that much in there, so much for compound interest.

Adam
Adam

Compound interest is great, but most people ignore the effects of inflation. People think that if they save $2k/yr for 40 years they’ll be MILLIONAIRES! Okay, that could be true, but what’s a million dollars going to buy you in 40 years? That’s not as big of a nest egg as it sounds.

Adam
Adam

This is Adam #6, I felt compelled to point out that I am not also Adam #5.

Nicole
Nicole

Of course, where compound interest really matters is those crazy debts… I shudder to think how much we’d owe if we hadn’t paid off that 8.5% student loan debt from college. I can’t even imagine people with 28% credit card debt or even worse, pay day lenders. That stuff subtracts up FAST.

Rachel (heart of light)
Rachel (heart of light)

So true! I opened a Roth IRA as soon as I graduated from college. I was working as a temp, so I didn’t have any sort of matching contribution plan to pay into. I was living at home briefly, so my expenses were low and my student loans hadn’t entered repayment yet. I maxed out my contributions for the first two years. I’ve since had to decrease my contributions slightly, but I still put a little in each month. My reasoning was that even if I couldn’t afford to put much into it later on, at least I would have… Read more »

Mel
Mel

I’m guessing based on the statements I receive for the retirement from some student jobs and the fact that such a return is highly unlikely that the “factors I don’t understand” are the assumption that you will keep paying in at that same rate.

Still, it’s something.

Phil
Phil

Keep drinking the kool-aid.

How much of that interest is earned near the end of your career?

In other words you would have to keep your money in the market and your foot on the pedal at the time where you can least afford a downturn.

Here’s some kool-aid: plan to work until you die.

Molly On Money
Molly On Money

I think the point isn’t just that he’ll have saved $1 mil. in 40 yrs but that the habit of putting a bit (or a bunch!) away every month is a good practice. Living on less than you bring in is a good practice for those unexpected times in your life (like losing your job or getting cut back in you job). My income recently dropped. If this had happened a year ago when I was living beyond my means it would have been incredibly stressful instead it was just a blip on the map.

Phil
Phil

Molly the reason that you can survive in those situations is because you made yourself flexible and adaptable (see Darwin). It’s not the “magic” of compound interest. Compounding your money is nice, but it isn’t the cure to all your ills. It looks great on paper, but there are a lot of assumptions that go into those percentages. A lot has to go right in the world for your magic formula to payoff as advertised. It’s this blind faith that got a lot of people in trouble in the first place. You have to pay attention to the world. You… Read more »

her every cent counts
her every cent counts

One thing that would go along way in helping us all learn more about money is giving each child a certain amount of money to invest when they are young. The child should be allowed to invest in low-risk ETFs and such, but be able to see the power of compound interest over time. If a kid starts investing at age 5, by the time they are 18 they will have had enough time to weather the ups and downs of the market and have a decent return, and understand the importance of saving. I wish I started younger (I… Read more »

Bonnie Crawford
Bonnie Crawford

I got on the net trying to find out if there is ANY bank anymore that pays fair compound interest on savings accounts anymore. I am almost 65 and can remember when our “passbook savings accounts” were paid 5% and 6% interest. NOW it’s only around .200%, which is insulting. In fact, anything below 5% is insulting and does not amount to ANYTHING, even when compounded. Greed has just taken over the country, with deregulation. Even credit unions aren’t paying anything anymore! Yes, I am frustrated and angry with greedy bankers who have become rich while squeezing out the middle… Read more »

Harm
Harm

However much or little Jess’s account will
actually be worth at retirement, it’s more than
a non saver will have. And more than most
people would expect him to have, THANKS to
compound interest….
Of course, thanks to the ‘war on savers’ here
in the states, I’m a bit soured on the ‘magic
of compound interest’ with bank accounts….
(Let’s see, at .5%, my money will double in….
nah, ain’t worth it. I’m just gonna buy a new
computer.)

Siebrie
Siebrie

I had a parttime job with a pension scheme for 6 months once. I paid in a total of €120 ($150), and it was doing nicely, bringing a profit of about €30 each year. However, the pension company’s fees were €45 each year, and what they could not take from the profit, they took from the main amount, leaving me with NOTHING after a few years. So beware! Too small a pension is not going to work. If my original amount had been double, I would still have it now, with a profit.

javier | growingrich.net
javier | growingrich.net

I never trusted in pensions. Why would I trust my money to a company who trades with MY MONEY in the stock market?

I prefer to do this myself, I get better returns.

Kevin
Kevin

@Nicole (#1): “Yesterday I was playing with the mortgage calculator and what paying extra at different points in the loan did to the final payoff date. It’s pretty crazy.” I agree that it can be empowering to see how much a single extra payment can knock off your mortgage, but the subject of this blog post is compound interest. It should be noted that compound interest has nothing to do with mortgages. Interest does not compound on mortgages. @Siebrie: Your comment is an excellent example of the old investment axiom that “fees matter.” Fees can cripple a portfolio’s performance, and… Read more »

Kevin
Kevin

Compound interest is a double-edged sword, in my opinion. While it’s obviously vital to building up a nest egg sufficient for retiring, the usual ways of applying it are very misleading, in a couple major ways. First off, the usual way of applying compound interest is to pick a number (say, 10%) and apply it every year for a certain number of years. This calculation is trivially easy: (1+x)^y will give you your multiplying factor, where x is the interest rate and y is the number of years. For example, applying 10% compound interest for 40 years gives you a… Read more »

Chris
Chris

Wow, it seems people don’t like compound interest, but I haven’t seen better alternatives proposed–I don’t think working ’til you die counts. “Kool-Aid” or not, Jess will now be saving for, and paying attention to, his retirement, which means he should be able to retire. Despite the economic downturn, there are plenty of retired people enjoying more than cat food for dinner because they saved and planned early. It does work, and I’d rather do that than get dressed for work at age 85.

Retirement is possible even if that interest compounds at only 7-8%.

Dan
Dan

Kevin #19:

I am pretty sure you are wrong about the 39 years of 7% and 1 year of 25%. Multiplication is cummutative.

1.25*(1.07)^39 = (1.07)^39*1.25

Kevin
Kevin

@Dan:

You’re right, if you’re talking about putting in one lump-sum in year 1 and just leaving it, with no further contributions, ever.

But for someone building their savings over time (like, for example, anybody who’s ever saved for retirement), contributing $x/month, my analysis is correct.

This kind of stuff is precisely what I’m talking about when I said conventional analysis of compound interest is dangerously misleading.

Robert Muir
Robert Muir

@Harm, re: war on savers. Harm the reason savings accounts are “only” earning .5% is because that’s the rate of inflation. To earn more than the rate of inflation, you MUST take risk. You could do the same thing by buying gold. Gold, historically only keeps pace with inflation. This, again, is because there is no risk. To pound a dead horse some more, (I loved Kevin’s take on Ramsey’s blather – I agree completely!), it’s impossible to earn “interest” at the rates being thrown about unless you’re talking about corporate bonds with a significant risk factor. My view is… Read more »

Paul in cAshburn
Paul in cAshburn

Really? A call center matched 200 pounds on a 100 pound pension contribution? (Now that’s a match!) Wow. We’re all over the map on this one. It appears one reply says having kids buy ETFs will teach them about compound interest (while capital gains and accrued dividends in an ETF are not the same thing as compound interest, unless we’re talking about a bond fund ETF – which may not work out well… see below). Other posters point out that most interest accrues toward the end of a saving program (which does illustrate the value of compound interest). So, I… Read more »

Robert Muir
Robert Muir

I agree Paul, bonds are not where I would be right now. Even money markets at 0% interest might be better.

erika
erika

I’m amazed at the intense reactions some people have had to this post. I didn’t realize anyone harbored such strong resentment towards compound interest 🙂 My main take-away from this article, in addition to highlighting the importance of saving early, was the “aha” moment that the pension statement provided. I think that’s what Nicole (#1) was referring to when she mentioned playing with the mortgage calculator. Not that mortgages and pensions are the same, but that looking at the concrete numbers can spur your motivation.

Karen
Karen

I put $4000 into a traditional IRA mutual fund when I had my first job in 1982&83. After that intial $4000 I added nothing more because I started grad school and got real poor etc.

It’s now worth $30,000.

Yay compound interest!

Mike
Mike

If you think that’s nice you should see the pensions of the state government workers. I did an internship with the state and learned all about the their pension system. They take 10% of your salary a year but you are rewarded handsomely after you retire. I’m not sure how they make it work but I don’t really care how they do it. I plan on taking a job with the state as soon as I graduate. State pensions are more reliable than 401ks and the stock market.

Phil
Phil

I’d like to know how many people have retired on their 401k / 403b / etc. compounded retirement plan alone? Not many would be my guess. I’ve done financial plans and those that retire comfortably have a defined benefit plan aka – pensions. Now those pensions are going away and we are supposed to rely more and more on the ‘magic’ of compound interest for our nest egg. Let’s hope they truly aren’t considering pulling the plug on social security. So the banks and financial companies are just going to sit around and let your accounts get fat and we… Read more »

Meilier
Meilier
chacha1
chacha1

Hey Kevin #19, thanks for at least understanding the difference between stock market gains and compound interest! Seems a lot of people here do not. I put in a comment last week but apparently it failed to save. The point was that stock market returns have absolutely nothing to do with interest earned on a bank deposit. Most pension plans do not put small participant deposits into the stock market. They put the deposits in a money market fund, which is essentially a bank account. Compound interest is, as Kevin noted, the interest earned/paid on the basic deposit over a… Read more »

TucsonDon
TucsonDon

I have been trying to find articles/postings on this subject for years. I have been maxing out my roth IRA since I was 18. The financial calculators and IRA sales pitches make the outcome at retirement (and 40 yrs of compounding) appear too good to be true…however I did not want to risk looking back and kicking myself for not starting early…after all saving is better than not. I understand how compounding interest works, however I can’t see how it applies to the stock market and its wild ups and downs. Hypothetically, your mutual funds could go up 7% a… Read more »

Robert Muir
Robert Muir

Compounding occurs in the stock market by reinvesting the dividends for more stocks. So as the stocks increase in value, the stocks purchased by dividends increase in value, throwing off more dividends that buy more stocks, etc. etc. To prevent the “boom, the market tanks in ’08 on the year you planned to retire” disaster, you utilize what you “know”; diversification. The closer one gets to retirement, the more stocks should be moved into more stable instruments. Any funds that are going to be required in 5 years should not be in the market – unless it’s too late and… Read more »

TucsonDon
TucsonDon

True about the dividends, but the champion of the IRA account is the mutual fund, and not all mutual funds pay dividends…they rely simply on growth appreciation.

So wheres the compounding in this scenario if the fund is not spitting out LT cap gains, ST cap gains, or dividends?

Robert Muir
Robert Muir

It would be a strange mutual fund that had no dividends. If a company doesn’t issue dividends, that usually means they are concentrating profits on growing the business which increases the value of the stock. So in theory, stocks that have little to no dividends will increase in value more than dividend issuing stocks. These are usually (but not always) “growth” stocks. The compounding is still there, it’s just behind the scenes. Just like humans, a company can spend their profits (issue dividends), buy back stocks, (increasing their value), or invest in growth, thus increasing profit (at times exponentially). We,… Read more »

Mark Jones
Mark Jones

I found this website helpful for learning about the benefits of compound interest http://www.inspiredtosave.com

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