The Power of Compounding Interest and Time on Investment Returns

Compounding Interest is interest (return) that builds on prior period interest.  Say you invest $1000 in an asset that compounds 10% annually.  This is how your investment grows overtime:

Rate of Return: 10% Annually

Initial Investment: $1000

• Year 1: $1,000    +   $100       = $1,100
• Year 2: $1,100    +   $110       = $1,210
• Year 3: $1,210    +   $121       = $1,331
• Year 4: $1,331    +   $133.1    = $1464.1
• Year 5: $1464.1  +   $146.41  = $1610.51

Notice how the annual gains increase overtime?  That’s compounding interest-money going to work to make more money.  This is why it is important to begin saving for retirement as early as possible so that the power of compounding has time to work its magic on your savings.  This is also why it’s important to pay down high interest credit cards-if you’re paying the minimum on a credit card charging 15% of interest over time you can end up paying several times more for that handbag or television than the initial purchase price.  Worse, money you’re wasting paying credit card companies interest is money you could be saving in your 401k-potentially at a this historical 9.8% average annual rate of return of the S&P 500!

Let’s take a look at the value of saving for retirement as early as possible.  In the graph above, the investor in blue begins saving $5,000 per year starting at age 22 until retirement at age 67.  The investor in red waited until age 40 to begin investing at double the rate-$10,000 per year-until retiring at age 67.  The investor who waited until age 40 retires with almost $1.2mln.  The investor who began investing at age 22 retires with almost $3.4mln!  The early saver has 2.88 times more money at retirement!