“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it,” is a quote attributed to Albert Einstein. Whether he actually said it or not is unclear [1].
Compound interest is often overlooked but is undeniably powerful. It’s the silent force that can turn modest savings into substantial wealth, especially for those with a long investment horizon. For professionals, who often have a strong grasp of complex concepts, understanding compound interest can be a game-changer in their financial journey.
Imagine planting a seed. Over time, with proper care and nurturing, it grows into a towering tree bearing fruit. Compound interest works similarly. Your investments are the seed; time, the fertile soil; and interest rates, the nourishing rain.
As your investment grows, so does the interest it earns, creating a snowball effect that can accelerate your wealth accumulation.
To make this concrete, let’s look at some numbers.
In a previous article [2], we noted that investing $78k/yr for 20 years and allowing it to compound at 9% gave you a total of $4M. However, if you didn’t compound the money and just put away the $78k each year, you would only have ~$1.6M at the end of 20 years. The majority of the money – $2.4M – comes from the impact of compounding the investment, not from what you are putting in. Interestingly, if you put away $78k once and let it compound at 9% for 20 years without any additional payments, you would end up with $437k and that would reach $1M in 30 years.
Ultimately, the power comes from being consistent over long periods of time. The combination of time, regular investments, and the interest you are generating on the interest you already generated all work together to affect the amount of money available. If you change any one of the three variables, or are inconsistent in your approach, the end result can change dramatically.
Consider the following table that shows how interest rate and duration impact the amount of money available when investing $78k/yr [3]
|
0% |
5% |
10% |
15% |
|
|
5yr |
$390,000.00 |
$430,999.24 |
$476,197.80 |
$525,905.74 |
|
10yr |
$780,000.00 |
$981,075.62 |
$1,243,119.12 |
$1,583,690.02 |
|
15yr |
$1,170,000.00 |
$1,683,127.96 |
$2,478,253.57 |
$3,711,272.05 |
|
20yr |
$1,560,000.00 |
$2,579,144.42 |
$4,467,449.96 |
$7,990,599.44 |
|
25yr |
$1,950,000.00 |
$3,722,713.71 |
$7,671,070.64 |
$16,597,855.36 |
|
30yr |
$2,340,000.00 |
$5,182,230.11 |
$12,830,533.77 |
$33,910,121.42 |
It is worth calling out that if you didn’t reinvest the cash flow from your investments – for example because you spent it to support your lifestyle – you would effectively be getting 0% compounding. If you were generating a 15% return but only reinvesting 5% of that, you would be in the 5% column.
Given how different the numbers can be based on both timeline and rate of return, it is a worthwhile exercise to run through different scenarios based on your current situation.
For example, assume you are 40 years old, have nothing saved, want to step away from your job at 55, and need $4M invested to support your lifestyle. You either need to increase how much you investment each year or consistently generate 15% compounded returns in order to have enough to retire. If you aren’t able to do either of those, you would either need to wait to retire or live on less than you are currently planning to. If you already had $350k saved, however, you would only need to generate 10%/yr going forward to hit your target.
Compound interest is a powerful tool that can help professionals achieve their financial goals. By understanding its principles and applying them consistently, you can harness its potential to build a secure financial future. Without that understanding, you won’t have a clear picture of what your net worth is going to be at a certain point in time, making it impossible to know if you are on-track to break your dependency on your paycheck. Remember, time, consistency, and interest rates are the key ingredients to unlocking the magic of compound interest.
If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.
For additional reading:
- https://www.snopes.com/fact-check/compound-interest/
- https://mbc-rei.com/blog/your-retirement-number-changes-based-on-your-investment-strategy
- You can regenerate this table using the FV function in excel https://support.microsoft.com/en-us/office/fv-function-2eef9f44-a084-4c61-bdd8-4fe4bb1b71b3
This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.