KJ: The compounding effect of wealth over time is quite significant – especially with a longer time horizon – so the sooner (and more) you begin to save, the better your long-term financial picture will be. Hopefully this post is not too dry – I mean, who wouldn’t like more money!
The effects of compounding interest over time is quite probably the best invention since, well, sliced bread!
Basically, the way that you make your interest earn you interest is that you let your savings grow and reinvest over time. Let’s look at a simple example (assuming a low interest rate of 3% – which is not all that low by today’s standards!):
Year 1: You deposit $1,000 in a savings account. You earn $30 in interest ($1,000 X 3%).
Year 2: You start the year with $1,030 ($1,000 + $30). You earn interest in the amount of $30.90. (i.e. your interest earns the extra $0.90 in income).
Year 3: You start the year with $1,060.90. You earn interest of $31.83.
Year 4: You start the year with $1,092.73. You earn interest of $32.78.
Year 5: You start the year with $1,125.51. You earn interest of $33.77.
Year 15: You start the year with $1,512.59. You earn interest of $45.38.
Year 30: You start the year with $2,356.57. You earn interest of $70.70, so your ending value would be $2,427.27.
So, while the numbers reflected above are quite small, you can see the impact of your $1,000 (without even accounting for any future contributions) over a long period of time – especially if you let the income reinvest!
If you had instead spent the income each year (or received what is called “simple interest” wherein your interest earned does not earn interest), you would end up after 30 years still only receiving $30 of interest, with a cumulative value of $900 in interest and $1,000 of principal (so $1,900). Compare this to the $2,427.27 figure, and you’re 28% lower than the alternative, and that’s for EACH $1,000 you deposit into your account. That adds up to HUGE differences over time.
The difference between the compounding versus non-compounding scenarios are exponentially higher with a longer time horizon and with higher return expectations. Consider our same example, but with a 6% return. With compounding of your interest, you would end up with $5,418.39 after thirty yeas versus a non-compounded 6% calculation that would yield only $2,800 – that’s a value of almost 94% higher and much more of a difference than our 28% calculation when we were looking at 3%!
AJ: There have been so many times where we have sat down to figure out how we can either reduce our expenses or increase our income to help advance our goals. This is an incredibly intelligent way to make your money work harder for you without having to reduce spending or increasing the amount you are contributing directly to savings. Appropriately investing your money is just as important as making the money and not overlooking incremental opportunities to grow your investments means getting ahead more quickly with the same contribution level.
Finding ways to just eek out an extra $10 in savings now means you’re potentially giving yourself the opportunity to have $54 later. It really makes you think about the true “cost” of everything today. Sure you know the sticker price listed today, but what does it potentially translate to the foregone future value? As with everything we preach, there’s definitely a delicate balance between the here-and-now versus always delaying for future consumption, but this perspective helps us differentiate between those “needs” and “wants” of ours.
- Is your interest paying you interest?
What are you doing to invest early to benefit from having time on your side?
Tell us how you save.
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