The miracle of compounding interest was undoubtedly the most valuable lesson of my entire education.
You: What is the miracle of compounding interest?
Let's take it one word at a time, in reverse. First: interest. You know interest. Interest is what savers are paid for saving. If you keep $600 in a savings account earning 2 percent interest for one month, you receive $1
of interest.
You: A buck? Big deal.
It actually is a big deal.
You: No, it's actually a buck. Even a Taco Bell $2 Meal Deal costs twice as much.
The absolute numbers aren't important yet. Hang with me.
You: Proceed.
The next word is compounding. Compounding is the frequency at which interest is calculated and paid. As a saver, you like frequent compounding.
You: Why?
Because you are paid quicker and more often.
You: That does sound nice.
Now for the miracle. Let's say you save $300 a month.
You: Excuse me?
Let's say you save $300 a month.
You: Now that would be a miracle! I don't have that kind of money.
Anyone employed can save $10 a day; you just have to be motivated. The miracle of compounding interest provides
that motivation.
The Miracle of Compounding Interest
Let's assume you take the $300 a month you'll be saving soon and earn an 8 percent rate of return.
You: What does rate of return mean?
Mathematically speaking, it's like interest.
You: But there aren't any savings accounts paying 8 percent interest!
No, there aren't.
You: So why use such a ridiculous example?
Since I wasn't thinking in terms of savings accounts, 8 percent isn't ridiculous. The best way to demonstrate the miracle of compounding interest is over the long term.
You: Where can I get an 8 percent rate of return or interest?
Most mainstream financial advisors re-commend investing the bulk of your long-term savings in the stock market. Although not guaranteed, the long-term historical average of the stock market is 8 percent.
Now it's time to experience the power of the miracle of compounding interest and you're going to tell me how powerful it is.
You: I am?
Yes. If you save $300 every month until you turn 65, how much money will you have?
You: I don't know-you're the CPA.
Take a guess.
You: I wouldn't even know how to begin.
How old are you?
You: None of your business.
Fine. Keep your age to yourself, but subtract it from 65. The difference is the number of years you will save $300 monthly.
You: Okay.
To convert $300 a month into an annual figure, multiply $300 by 12 for a total of $3,600 in yearly saving. To get the amount you'll have by age 65.
You: I'd multiply the number of years I'd save by the $3,600 saved per year.
Yes, but don't forget to add the interest you'll earn. Got your number?
You: I have a decent guess.
Look at the chart labeled Value, at Age 65, of Saving $10 a Day.
You: What's going on there?
Find your age. Then, look up until you find the line. From that point, look to the left for an estimate of the amount of money you'll have at age 65.
You: Are you sure?
Yup.
You: For just $300 a month?
Or 10 bucks a day.
You: That's a lot of money.
Ten bucks?
You: No, the amount of money I'd have at retirement if I only saved 10 bucks a day.
Now that's what I'm talking about. Look back at the graph again.
You: I still haven't taken my eyes off it.
The curved nature of the line illustrates the miracle of compounding interest.
You: How so?
The steeper the line, the greater the loss from not saving.
You: Meaning?
Your younger years are most valuable. Specifically, your twenties mean the most.
You: Still not following you.
If you move your finger along the line from age 21 to 25 or 31, you'll see the decrease is dramatic. But the decline from 41 to 51 is much less severe.
You: True.
Time is Your Most Valuable Asset
Let's compare Ginger, who starts saving when she's 21, to Rachel, who begins at 31.
You: Obviously, Ginger reaches retirement with more money than Rachel.
But the difference is striking.
You: I saw that already in the chart.
Look again.
You: Done.
How much money does Rachel have in retirement?
You: More than $600,000.
Yes, she has about $632,000.
You: A pretty good sum of money.
Indeed, proving those who don't take financial advantage of their twenties can still accumulate significant sums.
You: Good.
How much will Ginger have in retirement?
You: Nearly $1.5 million. That's a lot of dough.
It sure is-about $825,000 more than Rachel ends up with.
You: Wow.
Now think about how much less Rachel saved. From the point Ginger and Rachel reach age 31, they save the same amount. The only difference in their savings is their actions during their twenties. During those 10 years, Ginger saved $3,600 annually, or $36,000 in total.
You: Hold on a minute.
Yes?
You: I just realized something.
Here it comes.
You: The difference in what each saves is $36,000 but the difference in what they wind up with is more than $800,000?
About $825,000.
You: Is this for real?
As real as the taxes in New York and California. The $36,000 Ginger saves during her twenties grow to $825,000 by age 65.
Make Up the Difference Later?
Many 20-somethings think saving will be easier later.
You: Because they'll make more money?
So their thinking goes.
You: True, no?
Although most people will earn higher salaries later in their careers, many do not find it easier to save. For one thing, 30 percent of people earning six figures still live paycheck to paycheck. Sadly, a higher income alone does not cause savings.
You: So when should I begin saving?
Start saving when you start working.
Can You Make Up for Lost Time?
Let's say your goal is to reach age 65 with the same amount you could have had if you began squirreling away $10 daily at age 21.
As the bar chart shows, if you wait until age 26 to begin, you'd need to save $454 per month.
You: Versus $300? That doesn't seem like much of a difference.
At first, I thought the same thing.
You: But then?
I changed my mind.
You: Now you think it's a big difference?
Saving $454 instead of $300 is an increase of more than 50 percent per month. By waiting five years, the amount you must save each month is 50 percent higher than had you started at age 21. Furthermore, you must save the additional 50 percent for 40 years. That's 480 consecutive months!
You: That doesn't seem fair.
I agree, but that's the math.
Sooner or later, you must start. This year is the most important year of your life to begin. As such, I hope you're sufficiently motivated to become fiscally responsible-not cheap-and find your personal path to saving.
Michael B. Rubin, CPA, CFP is a frequent speaker and the author of Beyond Paycheck to Paycheck: A Conversation About Income, Wealth and the Steps in Between. His next book, The Savings Solution: A Conversation About Living for Today While Saving for Tomorrow will be released in January. For more information, visit www.totalcandor.com.