Illustrating Compound Interest

Exponenetial GrowthContinuing the discussion of Compound Interest, perhaps the best way to illustrate the phenomenon is through the story of two brothers, twins Ronald and Robert Smith.

Imagine that seven years ago, when they were 28 years old, they had a conversation regarding savings and investments.

Ronald noted that he had managed to reduce his debt and was prepared to invest $1,000 a year. Robert noted, regrettably, that he had not been able to reduce his debt and was not in a position to invest any of his income.

Flash forward to 2013 and the twins are now 35 years old. Ronald has been investing $1,000 faithfully during that time, earned 10% annually on his investments and is now sitting on a $10,435.89 portfolio [FIGURE 1].

During the previous seven years, Robert was not able to invest anything. Fortunately however, he is now at the point where he is able and prepared to invest $1,000 annually. While Robert is just now starting to invest, Ronald decides that he is no longer interested in contributing new money to his investment accounts.  Not something that I would recommend, but it makes the point, and this story, much more dramatic.

Fortunately however, he does decide to leave the $10,435.89 in his investment portfolio.  Over their birthday dinner (filet mignon, rice pilaf, and a nice Merlot) last Tuesday, the twins both expressed a desire to retire at 60 years of age, in 25 years.

Summarized, Ronald invested $1,000 a year for seven years, left the resultant $10,435.89 in place, but has decided to stop investing new money for the next 25 years. His total contributions: $7,000. Conversely, Robert did not invest any money during the seven years that his brother did; however, he did start contributing to his retirement accounts at the same time his brother stopped, deciding to faithfully contribute $1,000 annually for the next 25 years. His total contributions: $25,000. Which brother do you believe will have the larger nest-egg when they celebrate their 60th birthday?

Ronald Smith 1

As you probably suspected, even though he contributed $18,000 less, Ronald Smith [FIGURE 2] will have a larger nest-egg (+ $4,888.03) than his brother, Robert [FIGURE 3].

Ronald Smith 2

Robert Smith 1

It is likely that as you conduct research and learn more, you will come across different versions of this story. Regardless of the slight differences, the truth is the same…Compound Interest is a powerful force, one that you should use to your advantage by putting your money to work as soon as possible and minimizing fees, an inhibitor to building wealth and preparing for retirement.

A great Compound Interest calculator, my personal favorite, can be found at moneychimp.com.

Blogger-in-Chief here at RetirementSavvy and author of Sin City Greed, Cream City Hustle and RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit.

10 Comments

  1. Good exercise to show the compounding effects, awesome. I wished I had invested more in my 20s. I did invest but not enough to help me get Financially free sooner.

    • Like you, I wish I had started a little earlier. I got serious in my early 30s which isn’t too bad. However, every once in awhile I think about what a huge difference it would have made if I had started just 4 -5 years earlier. That compound interest is a beautiful thing!

  2. A Google+ reader notes…

    “I like it, now where can I get a 10% interest rate?”

    • Over the last 20 years, 1994 – 2013, the S&P has gained an average of 9% annually, just less than the 10%. A good low-cost index fund would have served you nicely.

      But of course you know that ultimately it isn’t about 10, 9, 8, 7 or any other percentage. The key is, everything else being equal, there is a distinct benefit to starting earlier.

  3. Great topic, James. Compound interest and time are two things that can make anyone rich, yet the powerful synergies of the two are not understood by many. Thanks.

    Jason (froogalist)

    • Thanks for stopping by, Jason. If individuals can learn to live a little more frugally – a concept you cover nicely at http://froogalism.com (a recommended site for SavvyReaders!)- and put their savings to work, they would be amazed at how much they put themselves in a better position for financial freedom, whether that be an eye toward retirement or some other financial endeavor.

Leave a Reply

Your email address will not be published. Required fields are marked *