January 10, 2017
Introduction
How old are you? If that question made you think of your age, you earn half credit. If you thought of your age, but were incorrect, you get a laugh. If you answered “Old enough!” you’re correct. You’re never too young or too old to start investing, but your age and how long you plan to work will determine how hard you have to work.
If you’re young and dream of working into your 60’s, then you have an easy financial road ahead. If you’re young and plan to retire by 30, your road will be significantly more challenging. If you’re 50 years old and haven’t started saving yet, and want to know when to retire, this post may make you wish you had learned about compound interest earlier.
Compound interest is defined as “interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.” In English, this means that your money earns money and the more you have, the faster it will grow. This is truly passive income, earning money while you sleep, doing all the work for you.
That sounds nice, but what’s the point?
The point is you’re making money without any effort. The sooner you start saving, the more compound interest you can earn and eventually the money you’ve earned will outpace the money you’ve invested. Let’s take a look at a few scenarios and graphs.
Scenarios
Carol, a 26 year-old Administrative Assistant, saves $500/month and plans to retire at age 60. Carol will invest for a period of 34 years, contributing $204,000 over the time frame ($500 x 12 months x 34 years).
David, a 22 year-old software developer wants to retire early, lives well below his means, and chooses to fully fund his Roth IRA and traditional 401k. He plans to retire at 32. David contributes $282,000 in his 10 year period of employment (($5,500 + $18,000) x 10 years).
Frank is 48 and late to the investing game. He has lived paycheck to paycheck, but recently learned of the power of compound interest. He’s going to invest as much as he can and wants to retire by 60. Frank is making more money than he ever has and is able to save $5,000 a month. He’ll have contributed $720,000 by the time he turns 60 ($5,000 x 12 months x 12 years).
Frank has contributed significantly more money, but who will have the most money saved by the time they hit 60 years old?
Carol: $769,552.59
David: $2,158,420.78
Frank: $1,073,307.08
What just happened here? David only worked for 10 years and sailed off into the sunset, yet he has more than double the amount of Frank, who worked up until age 60 and invested 2.5 times the amount of money as David! Carol invested the smallest amount of money, 3.5 times less than Frank, and she’s still managed to save more than three-quarters of a million dollars.
David is the clear winner in this scenario. He saved wisely and was enjoying retirement for 28 years before Frank turned 60. Will Frank still need to work? It’ll certainly be difficult for him to catch David’s nest egg, but he does have enough to retire.
How much do you need to retire? Find out here. Already know how much you need? Here’s how to get started investing and begin your path towards FIRE.
Begin saving now, regardless of your age, because the sooner the interest starts compounding the sooner you can enjoy the life you wish you had.
Assumptions: The example above assumes a 7% return - the average return of the S&P 500. The compound interest calculator used can be found at investor.gov. The math used for David was to contribute $1,958.33/month for 10 years, take the resulting number, set it as the starting principal, and invest it for the remaining 28 years assuming no further contributions are made.