Power of compounding: The Magic Wand
Compound interest is defined as the interest calculated on both the principal and the accrued interest. On the surface it just sounds like another boring mathematical concept that we were forced to memorize during school. Why should you care about it?
Tom contributed $5000 every year for 10 years towards his nest egg (Total contribution: $50000). He retired with $1.1 million.
Jerry contributed $5000 every year for 35 yrs, for his retirement (Total contribution: $175000). He too retired, but with $750000.
How did Tom’s nest egg grow to be twice the amount he contributed? Did Tom discover a stock that gave him such an extraordinary rate of return than Jerry, who contributed twice as much as Tom, was never able to catch up? No. The answer is Tom had the Magic wand – “Compound interest” do all the work for him. Now do I have your attention? The magic wand, the power of compounding, can work for you or work against you. Let’s look at both scenarios.
Making it work for you
Let’s go back to Tom. He contributed $5000 every year starting at age 21. He was consistent for 10 yrs then he stopped contributing. Tom didn’t contribute a single penny until he retired at 65. Jerry on the other hand was a late starter, he procrastinated saving for retirement until he was 30 and started contributing at the age of 31, but he was a consistent contributor from then on and saved $5000 every year for the next 35 yrs, until he retired. Both of them had the same rate of return – 8%. But because of the power of compounding, Tom who contributed less than 30% of Jerry’s capital, ended up with nest egg 1.25 times as large as Jerry’s.
The formula to make the power of compounding work for you :
- Start early
- Contribute consistently
- Don’t touch the money
- Let the “force” do the lifting for you.
Making it work against you
Now if Tom had payday loan or credit card debt. The magic wand that worked so well for his retirement would have penalized him hard for his debt. For a $5000 balance with 18% interest, if he were to make $200 payments every month, he would take 31 months to pay off that debt. The interest payment alone would have been $1032. So he will end up paying $6032 in total. If he could increase the payment by just $100 per month, he can get rid of the debt in 19 months and with payments totalling $5642.
Whether Einstein really made that statement or not, I hope these examples demonstrate that compound interest is one of the most powerful forces in the universe. Making it work for you or against you is the choice you have to make!