Compound interest is a very powerful force and the reason you need to start saving as early as possible if you want to retire with plenty of zeros at the end of your bank balance. It’s also why you should start saving early, even though you might not think you have enough money to make a real difference. But in a time of low interest rates, is compound interest still the magic force we think it is?
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What is compound interest and how does it work?
Let’s say you invested $1,000 into a high-yield interest savings account at the age of 20. You then add a further $100 every month for 30 years. If you have an annual return of 8 percent, your investment of $37,000 would become $146,078 by the time you hit 50.
However, if you decided not to start investing until you were 35 but then increased your contributions to compensate this (because you are now in a position to pay more in), then the outlook for your investment is very different. If you open a high-yield savings account with an annual interest rate of 8 percent then add $400 per month (four times as much as in the 20 year old example), by the time you hit 50 you will have invested a total of $73,000 and with interest added you would still only end up with $133,597 – less than the total the 20 year old ends up with but having paid out $36,000.
This is the benefit of compound interest, and it only works because of the two important factors needed: time and rate of interest. Having more money later on in your life doesn’t mean you’ll always catch up, because you have lost out in terms of time.
When low interest rates spoil the maths
So why is using compound interest not something everyone and their dog is doing? To answer that we need to look at the current interest rates, which are very low right now and have been for a long time. High interest rates are a gift, a variety of the “get something for nothing” scenario, of which there are a number of other perfectly legitimate ways of doing so, like buying a lottery ticket, or checking out the list of free bets from Oddschecker to place sports wagers with, or taking advantage of credit card rewards schemes.
The problem here occurs when it becomes glaringly obvious that the average rate of interest for a high-yield savings account is not 8 percent but 2 percent. In the scenario above, this means a 20-year-old opting for an investment of $1,000 initial investment and $100 per month over 30 years would have an end balance of $50,497. For the 35-year-old investing $400 per month, it means an end balance of $84,365. Which indeed suggests that it’s better to wait and invest more later in life.
Source – Pexels
So, regardless of who said that compound interest was the eighth wonder of the world (often mistakenly attributed to Albert Einstein), it’s only a valid and powerful weapon in the pursuit of a wealthy retirement if you have enough time to implement it and a high enough interest rate to make it work, because compound interest follows an exponential curve, enabling your wealth to grow exponentially alongside it.
As you can see, the math of compound interest is very real even when saving relatively small amounts, but there are two aspects within it which should be highlighted because they can be misleading. The first is that interest rates can change (they can go up or down for long periods of time, just like they are low right now). Secondly, the benefits of compound interest are pretty heavily weighted at the end of term.
Why millennials won’t be retiring at 40 because of compound interest
If you were lucky enough to start your investment in the 1980s, then the model of compounding your interest would have worked out quite nicely for you depending on your investment, because interest rates were much higher for much longer. When interest rates are high, it’s a really good reason to set some money aside in a savings account and wait for the interest to grow and your capital to increase in value. It is the story we are all taught from a young age from our parents and teachers: They said that saving is good – and for the most part it really is. But when interest rates start to fall, things don’t go exactly to plan.
So when compound interest was the most effective way of accruing wealth on wealth, interest rates back then were as high as 10 percent, which provides the answer as to why compound interest can be magic but only when given enough time and a relative interest rate to mix it with. There are many great stories of how compound interest allows you to retire at 40 or 50. However, with the credit crunch, stagnating wages, rising rent and a millennial attitude of purchasing over saving, it is an idea that isn’t being borne out across America.
However, while savings accounts won’t offer that kind of interest rate, there are still a number of other financial investments that still stay true to the formula of compound interest like the stock market. So while compound interest might be a hackneyed idea, it still rings true to wealth generators like Warren Buffet, and it pays to understand and use this formula given the right investment vehicle.