Compound interest examples

Compound interest examples

The power of compound interest

One of the easiest concepts in all of finance to understand is “simple interest”. When you make a payment on a loan with simple interest, the payment will initially go towards paying off that month’s interest, and then the remainder towards the principal value of the loan. Assuming you pay each month in full, the interest never accrues. Compound interest is slightly different, as it adds some of the monthly interest back onto the loan. That means in each successive month, you’re paying new interest on old interest. Simple interest loans tends to be fairly consumer friendly, particularly for people that pay their loan payments in full each month. Compound interest loans, since they add interest back onto the principal value of the loan can quickly grow and lead to a “runaway” effect that makes paying them down extremely difficult.

In my experience, most people have no problem grasping the difference between simple and compound loan interest. However, they are often unable to make the leap in understanding in the opposite direction. That is, compound interest has massive benefits to your investments over time, particularly if your dividends and interest are being reinvested to buy additional shares, and you’re receiving a free match through your employer retirement plan like a 401k.

Financial planners and savvy investors are often fond of lecturing other people about the importance of starting to save for retirement as soon as possible. Many people think saving for retirement in your 20’s is absurd, but there is a reason why this advice is so commonplace. It turns out that time is the most critical component of utilizing compound interest to your advantage. This is because compound interest leads to exponential growth of the size of your investment account. If you’ve waited until your 50’s to start saving, you’ll never benefit from the same type of exponential growth of somebody that started in their 20’s or 30’s. This is even more important if you're receiving free money (employer match) in which to compound your investments.

Consider the following thought experiment:

Imagine three people that take very different approaches to saving for retirement:

Sally starts saving $300 per month at the age of 25.

Jason waits ten additional years, and starts saving $300 per month at 35.

Kelly waits even longer than Jason and starts saving at 40, but in order to try to catch up, puts $600 into her account each month.

Who ends up with more money?

Sally, who began saving at 25, ends up putting a total of $144,000 into her account and, after all the compound interest takes effect, will have a balance of about $460,000 when she's ready to retire at 65.

Jason, who put off saving until he was 35, invests a total of $108,000, but has only about $251,000 in his account at the age of 65. Missing out on those ten years of interest means that Jason will retire with about 55% as much money as Sally.

Kelly, who started saving $600 per month at 40, actually ends up putting much more money ($180,000) into her account than Sally who started saving $300 per month at 25. However, even though she's put $36,000 more into her account than Sally she ends up with just $359,000 at 65, about $101,000 less than Sally's total at 65.

As you can see, the power of compounding means your total account value does not linearly correlate with how much you placed into the account. In other words, Jason waited 25% longer (10 years out of 40 in the workforce) before contributing to his retirement account, but he ended up with 55% less than Sally. More important is that you've had enough time to pass to allow your investments to grow exponentially.

Obviously, there are other advantages to a 401(k) plan like employer matching and tax deferment, but even with those aside, the power of compound interest means the best time to start investing is always as soon as possible. The earlier you start, the more time you have for interest and dividend payments to reinvest, buy more fractional shares, which leads to greater compounding in the future.

What are you waiting for?