This article was adapted from the Your Money Vehicle textbook.
Want to know why compound interest is a mathematical superpower? Let’s look at an example of two people who are starting their job at the age of 25:
- The first invests $5,000 a year until they’re 35, and then stop saving for retirement altogether, investing a total of $50,000.
- The second person lives it up until they’re 35, and then saves $5,000 every year until they retire, investing a total of $150,000.
So, who ends up with more money in retirement?
Your answer depends on how well you understand the “eighth wonder of the world,” compound interest. In this article, I’ll break down how compound interest works to increase your money and why you should start earning it now to maximize your retirement savings.
What is Interest?
Before you can understand compound interest, let’s go over the basics: what is interest?
When you lend someone money — whether a bank, a friend, or a business — you earn interest on that money. Interest is usually calculated as a percentage of the money you lent. Put simply, interest is a way to turn money into more money over time.
Now let’s look at the difference between simple interest and compound interest:
- Simple Interest: Where you receive interest payments based solely on the principal amount you borrowed. Your money “goes to work for you” and creates “new employees.”
- Simple Interest example: $100 at 5% over 5 years pays $5, $5, $5, $5, and $5, totaling $25.
- Compound Interest: You receive interest payments based on the principal amount you borrowed and the interest you have previously earned. This is when the interest you have created begins to create its own interest and creates a snowball effect that grows your money exponentially faster.
- Compound Interest example: $100 at 5% over 5 years pays $5, $5.25, $5.51, $5.79, and $6.08, totaling $27.63.
With compound interest, your money goes to work for you, creates new employees, and then those employees begin creating their own employees!
The Time Value of Money
Compound interest is your most powerful superpower when it comes to saving money for retirement, but don’t take my word for how important this concept is — take the word of one of the smartest people who ever lived.
Legendary physicist Albert Einstein believed there was an eighth wonder of the world, and it wasn’t an ancient monument or statue; it was compound interest.
“Compound interest is the eighth wonder of the world. She who understands it, earns it…she who doesn’t…pays it,” he said.
Einstein understood that there is value in not only earning money, but also creating money. This value is called the Time Value of Money (TVM). TVM states that $1 today is worth more than $1 a year from now, due to its earning potential. When you U.S.E. (understand, strategize, and are efficient) money to earn more money, money becomes your employee.
Let me ask you, would you rather be given $1,000 today or $1,000 in a year?
The most logical answer is $1,000 today, because then you can put that money to work and grow it over the course of the year. Because you’ve made this money your employee and earned interest on it.
Start Earning Compound Interest Now
Now that you understand compound interest, let’s return to the example of the two people saving for retirement:
- one saves $5,000 a year until age 35
- one saves $5,000 a year until retirement starting at age 35
Who ends up with more money? It’s hard to believe, but the person who stopped saving at 35 comes out ahead!
Using a 7% return and a long-time horizon, here are the results:
- Person 1: Saves $5,000 a year until age 35, then stops = $562,682
- Person 2: Saves $5,000 a year starting at age 35 = $505,354
Even though Person 1 only saves $50,000, versus Person 2’s $150,000, they come out $57,000 ahead at their retirement date with financial freedom! How is that possible? Person 1 understood how to make money work for them like an employee. They exponentially impacted their TVM by using the secret of the wealthy and putting time on their side.
Don’t only work for money. Treat it like your employee and make money work for you!
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