New Money Rule #3: Understand Compound Interest

New Money Rule #3: Understand Compound Interest

A new survey from the Transamerica Center for Retirement Studies indicates that for both part and full-time workers, more than half of the people surveyed believe they need at least $1 million saved by retirement. But more than half of them say that they “guessed” when asked how they estimated the amount of money needed for retirement. Only 27% say saving for retirement is their greatest financial priority, with 21% saying “just getting by” and 20% saying that “paying off debt” are their greatest financial priorities.

So how are we going to retire?

Pensions are now a thing of past generations, social security is likely going to look different for most millennials, and stock market returns experienced in past years are not a guarantee of future ones, if the first decade of 2000 was not enough an example. For so many people, the recession during the last 8-10 years has deteriorated retirement savings,  stifled the skilled job market, and discouraged growth for businesses. Due to only tepid improvements in the economy, it is possible we will see more of the same for years to come.

Because of all of this, the only way it seems to ever have enough money to retire is to work longer and save as much as we can. Beyond economic and external hurdles, there are mental ones. Another study, done by the NBER Retirement Research Center (thank goodness we have people who do this for a living!) found that 90% of Americans face two major mental blocks: “present-biased preferences” and “exponential-growth bias”. The first one relates to procrastination and not being able to exhibit patience when contemplating present and future tradeoffs, the second refers to the tendency to underestimate the exponential growth of an asset’s value over time due to neglecting compound interest. The study found that a majority of Americans believe that savings grow in a straight line; only 22% of the population who were surveyed understand that savings growth is exponential.

So today we are going to focus on just that: compound interest. If you understand it and apply it, has the power to determine whether you have enough money to retire someday or not.

The most simplified way I can describe it is that it means to earn interest on interest, creating the exponential effect of compounding interest. This allows your investment to grow faster and faster as time goes by.

This is hard for most people to grasp because not many things in life work in a linear fashion, not an exponential one. Things like bacteria and the decay of uranium have exponential relationships. Most growth in life happens in a linear fashion…your age, the number of dogs you’ll have in a lifetime, your cab fare, quadrupling your cookie recipe, and how many slices of pizza you can afford based on the money in your bank account.

The Question:

To illustrate the importance of understanding the concept let’s use an example: I start to invest money each month from now until I retire in 40 years at age 65. Let’s say I use one of the biggest asset managers in America today, Vanguard’s Retirement Income Fund (VTINX) which has an average annual return of 4.38% and is known for having extremely low investment fees (what they charge you to manage the money).

How much money will I have in 40 years with a simple $100 per month investment? How about a $1,000 investment?

The Answer:

With a recurring investment and compound interest going to work, my $100 a month investment turns into $119,325 which is about 2.5 times more money than I would have had had I put just put $100 in a bank account.

A $1,000 per month investment turns into $1,300,756 which is about 2.6 times more money than I would have had had I put $1,000 in a shoe box every month for 40 years and Lord knows how much more if I would have left it in my checking account, ripe for spending.

The Equation:

Future Value of Annuity Formula

P=payment (amount of money you’re going to invest each month)

r=rate of interest, expressed as a decimal; take your annual interest rate and divide by the frequency of payments; in our example, it would by 0.0438/12

n=number of periods you’re going to make the investment for; in our example it is 12 months x 40 years, so 480

Still need a visual? I found this one very helpful when trying to visualize exponential growth.

There it is. Like it or not, compound interest is likely to change your life more than the iPhone, Spanx, and Diet Coke combined. It can allow you to retire and live the kind of lifestyle you work for 40+ years for or, if you ignore its effects, it can put you years behind your retirement and savings dreams. There’s a reason Einstein called compound interest the eighth wonder of the world. Adhere to the math and reap the benefits; ignore it and suffer the downfalls of its’ absence.


Finance Girl (Morgan)

#personalfinance #compoundinterest #investing #money #finance #saving




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