Thoughts on Compounding Interest

Today I read an article which discussed the power of compounding interest and gave a very compelling example of its importance.  If you recall from my post on my motivation by fear, one of the reasons behind me focusing on my finances now, is that I felt like I was behind on reaping the benefits of compounding interest.

The article I read focused on an example of A who is 19 years old and starts putting away $2,000 each year for 7 years, then no contribution afterwards.  Assuming a 10% return, at age 65, A will have nest egg of $944,641.  Compared to B who starts putting away $2,000 each year starting at age 26 until they are 65.  At age 65, B will have a nest egg of $973,704.  The article showed a table with total contributions and yearly nest egg amounts from age 19 to 65 for both A and B.

The first thing that I thought of when I read this article was, where do I find something that will give me 10% annual returns every year until I turn 65?  The second thing I did was look at how much money A had when they were 26 years old (my age).  The amount A had at age 26 was $22,959.  The third thing I did was make 3 spreadsheets with the same information as A and B in the article, add my information, and compared different outcomes with different interest rates.

My information is no retirement contribution until age 25.  At age 25, I put in ~$10,000 and at age 26, I put in ~$15,000, for a total of $25,000 present worth.

Update: For my information, I am assuming a total of $25,000 invested at age 26, and assuming no contribution going forward, just for simplicity sake.

This amount includes market gains in 2009 and 2010.  This amount is also more than the amount A had at age 26.

The table below summarizes my spreadsheet findings.

Even though according to the simple example used in the article, I would still have a comparable nest egg.  This little exercise showed me that even though compounding interest is very important, the interest rate itself is just as important.  A 5 per cent difference in interest rate can mean 1/6th of the nest egg.   And let’s face it, a 5% interest rate is much more reasonable than 10%.

I also remember thinking back to when I was 19 years old.  To be able to sock away $1,000 a year was close to unthinkable.  Most of the money I made from various part time gigs was in a GIC savings account for college.  I would have never imagined to invest it in a stock market, or mutual funds.  I didn’t even know how those things really worked.  Much less put all my hard earned money into it.  So I understand the principle behind saving early, but I understand first hand why it is often not done.

My conclusion is that a good nest egg depends on your discipline to save, saving early, and also finding investments where you can get a consistent return.  But one thing the article is right on about is the earlier you save, the less you have to save later.  How early, depends on our individual situations.  And when I say you, I really mean me.

What are your thoughts on this?  What are some of your important financial lessons?

Cheers,

Photo source: http://www.1-formula.com/mathematical-formulas/compound-interest-equation1/compound-interest-equation2.html

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5 Comments

Filed under Finance, Personal

5 responses to “Thoughts on Compounding Interest

  1. Well I’ll definately be putting away $14000 for my future kids starting when thier 19 if thats the case!!!

  2. A lot of people assume too much with these examples. Like you’ll find an interest rate that high or that interest rates will remain at that rate. Right now, you’ll be lucky to find an interest rate over 1.30% in NY. The underlying message is still true, start saving early and you’ll have a lot more later in life.

    • Exactly.

      But what I first took away from that example was, put away $14,000 and you’ll have $1M by the time you’re 65. Which isn’t true. It wasn’t until I crunched the numbers that I saw the underlying message more clearly.

  3. I’ve always hated those diagrams where they have “Billy” saving $2,000 a year from 20-30 with compounding interest of 12% vs “John” saving $2,000 a year from 31 to retirement at 12% and never “catching up”.

    Mainly I hate these examples because there are no 20 years olds that I know who have $2,000 a year to SPARE. I made less than $5,000 a year when I was 20. I was a college student, I just tutored and did teaching assistant-ships. Then from 21 to 25 I just made $19,000 a year as a graduate student and had to pay rent and living expenses in San Diego. There is really no “real” room in these salaries we have in our early 20s to SAVE $2,000/yr and then on top of that to have the ability to chose investments that would give good returns.

    In fact, even now at 30, I’m not sure that I have the ability to chose investments that would give me 12% returns.

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