When it comes to calculating interest, the two basic choices are simple and compound. Simple Interest is calculated one time solely as a percentage of the principal sum. As an example, if the principle is $100, and the interest rate is 4%, the value at the end of the interest period (e.g. monthly, quarterly, semi-annually, annually) would be $104 (100 x 1.04).
Conversely, Compound Interest is calculated not only on the initial principal but also the accumulated interest of prior periods. Here ya go if you’re interested in the math …
The analogy I often use when discussing wealth accumulation is rolling a snowball. A snowball starts with a single flake [savings] and takes a while [time] to grow. However, as the snowball grows in size, with a larger surface area [compound interest], that larger surface area attracts more snow, faster.
Perhaps the best way to illustrate the power of compound interest, other than that giant snowball, 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.
Time and Money
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.
FIGURE 1. Ronald Smith: Ages 28 – 35
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?
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].
FIGURE 2. Ronald Smith: Ages 35 – 60
FIGURE 3. Robert Smith: Ages 35 – 60
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.