Thanks to Shannon at The Heavy Purse for inviting me to be a part of the Financial Literacy Awareness Carnival! Financial Literacy is an incredibly important topic and I feel honored to be a part of this event. Thanks so much Shannon! And now read on to hear about my biggest money “a-ha moment.”
Like most folks, when my hubby and I first began getting serious about improving our financial situation and saving for retirement, we did not know much about personal finance. We both love to read, so when it came time to educate ourselves about personal finance we naturally turned to books first. We bought and borrowed dozens of books on the subject.
My personal all-time favorite personal finance book is The Millionaire Next Door, but another favorite that was among the first personal finance books we ever read was The Automatic Millionaire. In fact, it was as I read that book, The Automatic Millionaire, that I would say that I experienced my biggest money “a-ha moment” EVER. My jaw simply dropped when I read David Bach’s explanation of compound interest and the power that it can have in your life if you put it to work for you, especially when you are young.
What is Compound Interest?
So what is compound interest, you ask? Well, many of you have probably heard of earning interest on your money when you put it in some sort of investment such as a brokerage account or retirement account. Compound interest simply means that over time, not only will the money that you have invested earn you more money, but the interest on your investments will earn you more money as well. Numbers help in examples such as this. Say you put $5500 (the current maximum annual contribution) in a Roth IRA in January 2013 and it is earning you an average return of 6%. That means that by the end of December 2013 you would have $5830. You made $330!! Which is pretty cool (since all you did was invest it and leave it alone), but it is when the interest compounds that things start to get really exciting. The interest will compound year after year as you leave the money in that investment.
For example, let’s say you were 19 years old when you put that money into the Roth in 2013. By the time you are 27 years old you would have $8766.16. But wait, you ask, if I was making $330 per year on my money and I let it sit for 8 years, my money will make me $2640 ($330 x 8 years), right? But Dee, you are saying that I will actually make $3266.16 on that money. How does that work?
That’s compound interest folks. Because you aren’t just making $330 per year. You are making 6% interest (in this hypothetical example anyway; hopefully you could make more than that but we will be conservative here) on the current amount in the account, which goes up every year that you leave it in there. THAT my friends is how it is possible for your money to make you more money Every. Single. Year. (well, as long as we assume an average 6% interest rate, anyway).
The Big Picture
Even with real numbers, it can sometimes be difficult to see the real magic of compound interest if you don’t look at the big picture. So let’s look at the big picture. I’ve created a table here that I think will really help to hammer this message home. It was, in fact, a simple table similar to the one here that I first read in The Automatic Millionaire all those years ago that really helped the magic of compound interest hit home for me in a major way.
3 Retirement Savers- 3 Very Different Strategies and Results!!
| Jessica | Jessica’s Balance | Ted | Ted’s Balance | Susan | Susan’s Balance | |||
| Age | ||||||||
| 18 | $5500 | $5682.03 | $0 | $0 | $0 | $0 | ||
| 19 | $5500 | $11,714.51 | $0 | $0 | $0 | $0 | ||
| 20 | $5500 | $18,119.06 | $0 | $0 | $0 | $0 | ||
| 21 | $5500 | $24,918.63 | $0 | $0 | $0 | $0 | ||
| 22 | $5500 | $32,137.59 | $0 | $0 | $0 | $0 | ||
| 23 | $5500 | $39,801.79 | $0 | $0 | $0 | $0 | ||
| 24 | $5500 | $47,938.70 | $0 | $0 | $0 | $0 | ||
| 25 | $5500 | $56,577.49 | $0 | $0 | $0 | $0 | ||
| 26 | $5500 | $65,749.09 | $0 | $0 | $0 | $0 | ||
| 27 | $5500 | $75,486.38 | $0 | $0 | $0 | $0 | ||
| 28 | $0 | $80,142.21 | $5500 | $5682.03 | $0 | $0 | ||
| 29 | $0 | $85,085.21 | $5500 | $11,714.51 | $0 | $0 | ||
| 30 | $0 | $90,333.08 | $5500 | $18,119.06 | $0 | $0 | ||
| 31 | $0 | $95,904.63 | $5500 | $24,918.63 | $0 | $0 | ||
| 32 | $0 | $101,819.82 | $5500 | $32,137.59 | $0 | $0 | ||
| 33 | $0 | $108,099.84 | $5500 | $39,801.79 | $0 | $0 | ||
| 34 | $0 | $114,767.20 | $5500 | $47,938.70 | $0 | $0 | ||
| 35 | $0 | $121,845.79 | $5500 | $56,577.49 | $0 | $0 | ||
| 36 | $0 | $129,360.97 | $5500 | $65,749.09 | $0 | $0 | ||
| 37 | $0 | $137,339.67 | $5500 | $75,486.38 | $0 | $0 | ||
| 38 | $0 | $145,810.48 | $5500 | $85,824.24 | $0 | $0 | ||
| 39 | $0 | $154,803.76 | $5500 | $96,799.71 | $0 | $0 | ||
| 40 | $0 | $164,351.71 | $5500 | $108,452.14 | $0 | $0 | ||
| 41 | $0 | $174,488.57 | $5500 | $120,823.25 | $0 | $0 | ||
| 42 | $0 | $185,250.64 | $5500 | $133,957.40 | $0 | $0 | ||
| 43 | $0 | $196,676.49 | $5500 | $147,901.62 | $0 | $0 | ||
| 44 | $0 | $208,807.07 | $5500 | $162,705.90 | $0 | $0 | ||
| 45 | $0 | $221,685.83 | $5500 | $178,423.27 | $0 | $0 | ||
| 46 | $0 | $235,358.93 | $5500 | $195,110.05 | $0 | $0 | ||
| 47 | $0 | $249,875.35 | $5500 | $212,826.04 | $0 | $0 | ||
| 48 | $0 | $265,287.12 | $5500 | $231,634.71 | $0 | $0 | ||
| 49 | $0 | $281,649.45 | $5500 | $251,603.46 | $0 | $0 | ||
| 50 | $0 | $299,020.97 | $5500 | $272,803.84 | $6500 | $6,715.09 | ||
| 51 | $0 | $317,463.93 | $5500 | $295,311.81 | $6500 | $13,844.35 | ||
| 52 | $0 | $337,044.41 | $5500 | $319,208.02 | $6500 | $21,413.33 | ||
| 53 | $0 | $357,832.57 | $5500 | $344,578.10 | $6500 | $29,449.14 | ||
| 54 | $0 | $379,902.90 | $5500 | $371,512.95 | $6500 | $37,980.59 | ||
| 55 | $0 | $403,334.48 | $5500 | $400,109.09 | $6500 | $47,038.24 | ||
| 56 | $0 | $428,211.27 | $5500 | $430,468.97 | $6500 | $56,654.55 | ||
| 57 | $0 | $454,622.40 | $5500 | $462,701.38 | $6500 | $66,863.96 | ||
| 58 | $0 | $482,662.52 | $5500 | $496,921.81 | $6500 | $77,703.08 | ||
| 59 | $0 | $512,432.08 | $5500 | $533,252.89 | $6500 | $89,210.72 | ||
| 60 | $0 | $544,037.77 | $5500 | $571,824.79 | $6500 | $101,428.13 | ||
| 61 | $0 | $577,592.83 | $5500 | $612,775.72 | $6500 | $114,399.09 | ||
| 62 | $0 | $613,217.50 | $5500 | $656,252.41 | $6500 | $128,170.06 | ||
| 63 | $0 | $651,039.41 | $5500 | $702,410.65 | $6500 | $142,790.40 | ||
| 64 | $0 | $691,194.09 | $5500 | $751,415.83 | $6500 | $158,312.49 | ||
| 65 | $0 | $733,825.43 | $5500 | $803,443.54 | $6500 | $174,791.95 |
Look At Jessica!
Basically, this table describes three fictional people saving for retirement. Jessica starts saving at age 18 and maxes out her Roth IRA ($5500 per year, or $458.33 per month), for ten years. She then decides that she is done saving for retirement. Assuming an average 6% rate of return and monthly compounding, she will wind up with $733,825 to retire on at age 65. Her total lifetime contribution: $55,000 ($5500 x 10 years).
But Did Ted Come Out Ahead?
Ted gets a later start than Jessica. He does not start saving for retirement until age 28, but he contributes $5500 per year, or $458.33 per month, every year from age 28 until age 65. Again assuming an average 6% rate of return and monthly compounding, he will have $803,443 to retire on at age 65. So he did come out with a little bit more in retirement savings than Jessica, but did you see what happened there?
Ted saved $5500 per year for 37 years in order to come out with that much money at age 65. That means he contributed a total of $203,500. He contributed almost four times the amount that Jessica did and he came out with only slightly more! Why? Because Jessica’s money had longer to compound since she started saving at age 18!! Smaller amounts of money can turn into bigger amounts of money when you start early, thanks to the magic of compound interest. There is a reason why Albert Einstein called compound interest the eighth wonder of the world, folks!
Susan Started Late
The last column on the chart shows a fictional retirement saver named Susan. Susan really did not do much to save for retirement until age 50. She did then get her act together and saved the maximum $5500 per year in her Roth IRA plus the $1000 catch-up contribution for those ages 50 and older. But by now you can probably guess (and see on the table) how well that turned out for her.
Even though she was saving a bigger amount per year, because she did not start saving until age 50 she missed out on her biggest opportunity to really take advantage of the magic of compound interest, and at age 65 she only had $174,791 (again assuming a 6% interest rate and monthly compounding).
My Biggest A-ha Moment
It was when I really understood the power of compound interest and the huge role it can play in my life that I had my biggest “a-ha” moment ever in terms of personal finance. Please also understand that compound interest can unfortunately work similarly against you if you do things like carry a balance on your credit card- in that instance, you can be helping your credit card company benefit from the magic of compound interest! Say it isn’t so!! You definitely want to create a situation where compound interest can work for you, NOT against you.
Getting compound interest working in your favor is a great way to increase your net worth. My favorite FREE online resource to help monitor your net worth and plan for retirement is Personal Capital (review here). Signing up for a Personal Capital account has really helped us get a better handle on our finances in general, but retirement savings in particular thanks to neat tools like Personal Capital’s 401(k) fee analyzer. And best of all, it’s absolutely free.
What do you think- is compound interest presently working for or against you? Have you experienced any financial “a-ha moments?” If so, please share!
* Numbers in table as calculated on compound interest calculator found at http://www.thecalculatorsite.com.
P.S. If you liked this post, you might enjoy using our free Net Worth Calculation Template. Sign up now to receive each new post delivered to your inbox, and we will email you the template! Sign up here.
Photo: nattapol/Depositphotos.com
Those are very powerful numbers Dee. My high school students are always amazed when we cover the concept of compound interest, investing and time in my personal finance class. This is clearly a concept that the earlier you understand it the better off your financial life can be.
Definitely! Unfortunately I didn’t have this a-ha moment until my mid-20s, so I missed out on some good compounding years, but I still think that figuring it out in mid-20s is better than some folks. That’s AWESOME that you teach this to your high school students- what a huge benefit to them!
Great post, Dee!! We are working hard to teach our kids both the dangers (as in taking out loans/credit card balances) and the benefits of compound interest. Important stuff!
Good for you! They will be so much better off for having learned this important info- it’s so sad that some people never learn this until they are getting close to retirement (or never learn it at all!)
Nice explanation of the compound interest just a shame that I’m more of a Ted than a Jessica. We certainly put money away every month but we were a little off the mark in regards to age and amount. This would certainly be one thing that I would change if it were possible.
Same here. The unfortunate thing is that most people either never learn this until later in life or if they DO learn this in their teens they may not have much (or any) money to put away at that time! I think it’s hard to be a Jessica, but if you can manage to pull it off you’ll be sitting well in later years most definitely!
Compound interest is such a beautiful “gift” and I think that many people don’t have the patience to watch it take hold so they don’t get to enjoy the benefits of it. I always tell people that it is a long road to financial health and freedom and with patience, it’s amazing what they can accomplish.
Well said!
This reminds me of this book I had as a child. It was all about if you saved $10 now, how much it would be in 100 years. I remember being fascinated by how all of that worked!
I know, it’s pretty amazing! The more I read about compound interest, the more I completely agree with Einstein- it really is the eighth wonder of the world!
It’s always crazy to see tables like that and see how much it helps you by starting early. I never believed it, for some ridiculous reason, when I was first starting out and still kicking myself over it. That said, it’s definitely working for us now – I just want more of that time back. 🙂
I know, isn’t it nuts? This is a big part of the reason why we chose to start investing with our first jobs and let our low interest rate student loans hang around longer. We now feel that we have a solid starting nut for retirement, and now we are getting around to paying off the debt. I know it’s the opposite way from how lots of folks do it, but we just couldn’t wait to begin letting compound interest work for us!
I LOVE that compound interest was your biggest money a-ha. It is such a great lesson and one too many people don’t realize. They vaguely understand it’s bad when it comes to credit card interest, but even then they don’t completely understand how it works against them in that instance. Right now I’ve been working with Lauren on understanding compound interest and it was certainly eye-opening to her. As I certainly hope that chart you included is eye-opening to your readers. People always assume they need a huge amount of money to start investing, that’s not true at all. A small amount, given plenty of time to grow, can turn into a significant amount of money. Thank you for sharing your money a-ha and I have no doubt you’ve given people some great food for thought! I appreciate your participation in the Financial Literacy Awareness Carnival, Dee!
Thanks for inviting me to take part in the carnival, Shannon! Much appreciated!
Compound interest rocks- as long as it’s working in your favor- if it’s adding to your debt load, then it sucks!
I hear you there. We are still paying off our student loans, so we have a little bit of that compound interest working against us at this point. But we have more working FOR us in our investments, which is a pretty great feeling.
I love David Bach’s books and always try to give a copy of The Automatic Millionaire to kids I know when they graduate from college. I only wish I’d read it when I was in college.
That’s a great graduation gift! I really love that idea, might have to do that too.
Compound interest is pretty amazing, but it also bums me out a little. To take advantage of it fully, you need to start so young. Between 18-25 I barely had enough to save, let alone contribute to any retirement accounts. I guess this is just the kick in the pants to save as much as you can as soon as you can because it really does make all the difference.
I think to see the most amazing results you need to start really young, but as you can see in the table you can still start in your mid-20s or later and wind up with a pretty great result! I never read David Bach’s book until I was in my mid-20s, and for us it was hugely motivational since, as you said, we already felt like we were behind the game. We really stepped it up and started saving our butts off after that!!
Compound interest is the reason I am so sad I didn’t save for retirement in my mid-20’s. I didn’t make very much, so I couldn’t saved that much, but still. Compound interest!
I know, I wish I’d read that book or had any money to save (or a decent job that provided retirement benefits, for that matter) when I was in my early 20s. It’s hard to start young, but you can really see some magic happen if you do!
David Bach’s Automatic Millionaire was the first personal finance book that I read. I was already interested in investing and finance stuff, but it was that book which really inspired and motivated me. When you’re just starting out…millionaire status seems like such a lofty goal, but the way he broke it down, explaining compound interest, investing early, etc…it made it seemed very attainable. And I also think the Millionaire Next Door is an excellent book. Too many people think that millionaires live the high life when the majority are savers and frugal.
The cool thing is that I think it IS attainable if you start early and watch your lifestyle! I agree, it’s a very motivational book, definitely on my list of top personal finance books.
Dee this is so eye-opening for anyone who hasn’t seen this kind of thing. They should show it to every student in high school and college! Unfortunately, interest rates on savings accounts is pretty low these days and searching for higher yields usually puts you into more risky investments. Still, it’s better to save with some kind of return than to get no return or worse to just spend the money. At some point, it’s a good idea to consult with a financial planner to see what adjustments to make. Most people who do this are new parents. Thanks for this chart–it’s awesome!
Thanks Maggie! I’m glad you like the chart cuz I didn’t want to plagiarize Bach’s work so I made this one (which kinda took a while, but I think that seeing the numbers is really important here). You’re so right that interest rates on savings accounts are in the toilet these days, I was thinking more along the lines of a retirement account or brokerage account invested in index funds or ETFs or something similar to provide the higher yield.
I think that was my first personal finance book too. Loved the examples Bach gave in the book and his stories really resonated with me. I just wish I would’ve come across this sooner. 10 or so years later after reading it, those numbers are a tad bit depressing to me now. Ha! Damn you, Jessica! I got some catching up to do 🙂
Ha! I know, I read the book in my mid-20s and felt the same way. But if nothing else it was the motivation I needed to get my butt saving/investing as early as possible. I want to be able to feel some of the magic that Einstein was talking about one day!
Powerful, indeed! I was naively cheering for Ted until you pointed out how much more he had to contribute to come out ahead. Go Jessica! Imagine if she contributed even longer?
Exactly! She put in so much less money, and spent so much less time investing. Ideally she would have gone longer, but the table demonstrates the realm of possibility when you start early. Wish I had started at age 18!!
Compound interest is the main reason I invest in dividend stocks. I know that no matter what the stock prices do I will always get a small return each year that I can reinvest. The key is that I never spend the earnings and always reinvest it. I know it will turn in a larger amount eventually. Now if only I had patience 🙂
I hear you there! We invest in some dividend paying stocks and mutual funds too, and we reinvest the dividends like you do. We actually started our investing during the recession so we’ve already seen some nice gains, but it will be so much more after years and years. Investing really can be fun, and I think the most fun part is watching it grow!
Compound interest really rocks, good article!
Thanks! My favorite way to make money is while I’m sleeping- and compound interest makes it possible!
I hear you there! We invest in some dividend paying stocks and mutual funds too, and we reinvest the dividends like you do. We actually started our investing during the recession so we’ve already seen some nice gains, but it will be so much more after years and years. Investing really can be fun, and I think the most fun part is watching it grow!