Many people have heard that Albert Einstein referred to compound interest as the most powerful force in the universe. If I were to be so bold, I would suggest that compound interest plus time is the most powerful force. And if you happen to have lots of time, the effects can be staggering when it comes to your retirement.

The Basics

Compound interest is essentially earning interest on interest you have already earned. For example, if you invested $1,000 at the beginning of year 1 at a 10% interest rate, at the end of year 1 you would have earned $100 dollars and now have $1,100. So, at the beginning of year 2, your invested amount would be $1,100, and you would then earn interest during year 2 on the $1,100.  You may have heard the term “letting your money work for you” or “work smarter not harder”. Compound interest does exactly that. You are earning interest on money that you “put to work” while you don’t need it, so it is there for you when you do.

Rate. The rate is the percentage return your investment is earning you. In the above example, the rate was 10% or $100. Typically, but never guaranteed, the rate of your return increases the more aggressively you are invested. There are several factors to help you determine the amount of risk you should take and how to create a plan based on an expected rate of return.

Time.  Time could be one of the biggest factors to help you determine your risk tolerance and objective for investing, but as we will find out, it is one of the most powerful tools for growing your wealth. The little bit of interest in the example above may not seem like much at first, but the longer your money can work for you, naturally, the bigger it will become. Time is a major factor especially in the latter years when your money really begins to exponentially grow. That is why your financial advisor is so adamant about starting early. Let’s look at some examples below that could change the way you start saving today.

What does this mean for you?

Take the following example comparing interest rates for different time frames.

The value of $1,000 over time 

$1000 Invested @ 4% 6% 8% 10%
10 years $1,480 $1,790 $2,158 $2,593
20 years $2,191 $3,207 $4,661 $6,727
30 years $3,243 $5,743 $10,062 $17,449
40 years $4,800 $10,285 $21,724 $45,259

Now remember, we are looking at the power of compound interest when we only put $1,000 to work for us. At first glance you might conclude that the funds will grow in proportion to their respective interest rates. But with only a 2% difference in rate, the return is OVER DOUBLE in each scenario after 40 years. Would doubling your investment for retirement be meaningful to you? The power of time and compound interest is a powerful tool to help you do that.

Now let us imagine a scenario where 2 people, invest the same amount of money, for the same amount of time, but one waits until he is 35 to start investing.        Richard and Tommy

 

Year Richard   Tommy
1 $5,006   $0
2 $10,412   $0
3 $16,250   $0
4 $22,556   $0
5 $29,366   $0
6 $36,720   $0
7 $44,664   $0
8 $53,242   $0
9 $62,507   $0
10 $72,513   $0
11 $78,314   $5,006
12 $84,579   $10,412
13 $91,345   $16,250
14 $98,653   $22,556
15 $106,545   $29,366
16 $115,069   $36,720
 17 $124,275   $44,664
18 $134,216   $53,242
19 $144,954   $62,507
20 $156,550   $72,513
21 $169,074   $83,320
22 $182,600   $94,991
23 $197,208   $107,596
24 $212,985   $121,209
25 $230,023   $135,911
26 $248,425   $151,790
27 $268,299   $168,939
28 $289,763   $187,459
29 $312,944   $207,461
30 $337,980   $229,064
31 $365,018   $252,395
32 $394,220   $277,592
33 $425,757   $304,805
34 $459,818   $334,195
35 $496,603   $365,936
36 $536,332   $400,216
37 $579,238   $437,239
38 $625,577   $477,224
39 $675,624   $520,407
40 $729,673   $567,045

 

To summarize what just happened in our scenario, look at it this way.

Richard

  • Invested $48,000 of his own money over 10 years
  • His $48,000 grew to $729,673 at 65 years old

Tommy

  • Invested $144,000 of his own money over 30 years
  • His $144,000 grew to $567,045 at 65 years old

Tommy invested for 30 years and could never catch Richard, who only invested for 10 years. Had Richard not stopped after 10 years and continued to save for the same 30 years and then stopped, he would have accumulated over $1.2 million dollars when he turned 65. Over double what Tommy saved. The only difference was time. Richard started right away, and the reward was exponential.

When you start thinking about saving for your future. Remember, whatever is keeping you from starting today could be the one thing that has the greatest impact on your retirement. The more time you have, the better off you will be in overcoming the hurdles along your journey. The average American waits until they are in their 50’s to start saving for retirement. Richard allowed his money to work smarter when he started contributing at 25 years old and the opportunity cost was steep. While Tommy started at age 35, imagine the cost had he waited until he was 50.

Micah Schmidt

Micah Schmidt

Full Bio

As a financial advisor at PCIA, Micah Schmidt's passion is to help people develop meaningful financial strategies. He concentrates on developing financial plans for individuals along with corporate retirement plans. Micah received his bachelors from Kansas State University, and holds the FINRA Series 7 and 66 securities registrations.
Micah Schmidt

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