Compound Interest

Ultimately the two most important factors in growing money is the size (%) of growth (rate of return or ROR) and the rate of growth (or the number of times the investment earns interest on a certain balance total, that interest is added to the balance, and then the investor begins earning interest on this new, higher amount).

This is why investing in something that will return 5% in 1 year is much worse than an investment that will return 5% quarterly or 4 times a year as illustrated below:

Year 1: $1,000 (5%) == $1,050

-vs- 

Quarter 1: $1,000 (5%) == $1,050.00

Quarter 2: $1,050 (5%) == 1,103

Quarter 3: 1,103 (5%) == $1,158

Quarter 4: $1,158 (5%) == $1,216

Would you rather receive $1,050 or $1,216 dollars after one year of making a $1,000 dollar loan? 🤔

The power of compound interest is even better illustrated in a chart of growth over a period of several years. The below chart illustrates earning 10% per year on a $1,000 investment for 10 consecutive years.

An example with more money and more growth shows more clearly the power of compound interest

The below graphic shows clearly how important it is to save early. In it, Amy is able to earn enough in 10 years of savings, to earn more over the course of 34 years by simply earning interest off the savings of her initial 10 years of investing. No more contributions- just by earning interest she will have earned more than someone else who skipped those first 10 years and began investing later in their career.

In fact, Ethan contributes $100/month for 24 years and is not able to earn as much as Amy did contributing $100/month for just 10 years because Amy began putting her money to work much earlier than Ethan.

So 10 years go by, Amy consistently saving, Ethan consistently not saving anything. Now(?) Ethan, deciding he needs to begin saving for retirement is starting out with a much lower investment ($1,239.72) than Amy is already at by year 10 ($17,485.70).

The true power of compound interest is in the utilization of time and the time value of money. Because money that is invested wisely (presumably) always has a positive return, if you forgo savings (as I and many of my generation have) earlier on in your career you are incurring a huge opportunity cost; that opportunity being 10 years of 10% growth on $100/month investment with compounding interest.

Ethan chose to decline that opportunity and paid for it by losing out on all of that investment + compounded interest he could have received in the first 10 years of his career ($17,485.70), like Amy did.

Simply put, if you plan to invest (in safe, sound investments), the earlier you start the better off you will be. You cannot buy back time and time is a key ingredient to the growth of money.

Amy (wisely) began investing much earlier than Ethan and because of it, she is able to invest far less and still earn more.