So What Is Compound Interest?
Compound interest is an interest added to the principal of deposit or investment so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding. An example of compounding is when you invest $1000 and it generates a 5% interest, you will earn $50 in interest during the first year. However in the second year, not only will you earn interest on the principal, you will also begin to earn interest on the interest plus the principal in the account. So in the second year, the 5% interest will be credited in full $1050 you have in the account which will make your total account value $1,102.50. I know it doesn't sound like a lot in the beginning however if you kept the same $1,000 investment for a really long period like 20 to 30 years, you will see the compounding miracle.
Benefit Of Starting Early (TIME)
Benefit of starting early is that you have time working to your advantage, so the earlier you start the longer you are able to let compound interest working in your favor. Let's say you are lucky enough to be able to start investing at the age of 18 and you invested $1000 that generate dividends of 5% annually. Just by leaving the money alone and not touching it, it would generate handsome amount of $9,906 by the age of 65. The following year, it would generate you an interest of $495.30. That's a huge increase from original $50 interest you received in the first year. You are not even adding additional money to the account, imagine if you actually do! I have created a graph in the bottom to illustrate the power of of compound interest.
$1,000 Compounded Annually at 5% Interest Rate From Age 18 to 65 (47 years) |
As you can see from the graph, as interest accumulate in the later year, the account value increases faster every year. What I'm trying to explain is, that if you start saving and investing in early age, you have the upper advantage of accumulating wealth.
Comparison Between Who Start Early and Later
In this example, I want to show you the difference between two people who start investing in early age and who start later. These are two completely different people and are both the age of 22. They both have just graduated from their university and started to have a job that provide them income. Bunny is a smart person. He understands the concept of compound interest and wants to start investing as soon as possible. He spends less than what he earned which enable him to save the rest. While Erica has completely different mind set. She wants to really enjoy her income out of her new job. She doesn't really care about the future because she believes that she wants to enjoy life while still young. She spends everything that she makes and doesn't even save a penny.
In this example, I want to show you the difference between two people who start investing in early age and who start later. These are two completely different people and are both the age of 22. They both have just graduated from their university and started to have a job that provide them income. Bunny is a smart person. He understands the concept of compound interest and wants to start investing as soon as possible. He spends less than what he earned which enable him to save the rest. While Erica has completely different mind set. She wants to really enjoy her income out of her new job. She doesn't really care about the future because she believes that she wants to enjoy life while still young. She spends everything that she makes and doesn't even save a penny.
Bunny is really savvy when it comes to saving. He was able to put $5,000 per year into an investment fund. Let's assume that this investment fund will generate about 8% annual return (pretty conservative measurement considering the fact that S&P 500 generate more annually). He does this every year and by the age of 32 he decides to stop. In those 10 years, from age 22 to 32, he contributed a total of $50,000 ($5000 x 10 years).
After 10 years at the age
of 32, Erica begins to realize that she needs to have some money for her future
retirement. She too decides to start contributing to her investment fund.
Trying to match it up with Bunny, she also contributes $5,000 a year that
generate 8% annual return. Feeling for being late, Erica decides that she would
continue to contribute $5,000 per year until the age of 65. I display below the
two savers' investment at the age of 31.
As you can see, Bunny already has approximately $78,227.44 in the account by the age of 31, and Erica didn't even put a single penny yet. The time Bunny decides to stop contributing in was the time Erica decides to start. But who will have a higher ending value at the age of 65? Let's take a look at the chart below.
At the age of 65, even though Bunny has stopped investing after the age of 31, he will still have an awesome amount of $1,070,944.07 in his account while Erica will only have $856,584.02. That's a difference of $214,360.05!
You also have to account the fact that since Erica invested at the age of 32 to 65 (33 years) while Bunny invested at the age of 22 to 32 (10 years). Erica contributed $165,000 into her account compared to Bunny who only contributed $50,000. That's a major difference of $115,000 more Erica contributed and yet she still lost to Bunny by $214,360.05. Pretty suck for Erica!
I just hope after reading this article you readers have a different view of why you should start investing early. The sooner you get started, the more opportunity you have for compound interest to work in your favor. So don't procrastinate anymore and start investing now!
Sucha good way to explain abt comp inteterest! I need to start investing as soon as i hv the money .
ReplyDeleteThanks for reading my article. I hope this article will inspire you to start saving & investing.
DeleteAnonymous missed the point. Start investing now! Any amount can start your lifetime habit.
DeleteLiterate and easy to comprehend. Maybe the next article could be on variation of interest rates in different nations and how real interest rate plays a part of compound interest as well? :)
ReplyDeleteGreat, easy to read article!
ReplyDeleteHey Unknown, Thanks for reading my article.
DeleteDGB,
ReplyDeleteI'm one of the many milennials and I can't tell you how many times I've tried to open up conversations with the friends about the importance of saving/investing NOW rather than simply living paycheck to paycheck. It's great to read articles that further support that it's a great strategy for riches over time and therefore independence from an employer that you probably don't care to work your whole life for in a shorter time. Liked the read, will add you to my followed blogs list.
-Dividend Monster
Hey Dividend Monster, Thanks for reading my articles. I'm a new blogger and will be writing more in my spare time. I will add your blog in my blogroll. I hope you will succeed in the pursuit of financial freedom.
DeleteIt's too late for me to experience the true power of Compounding. My kids however, will be vary happy that I forced them to start ROTH IRAs when they started working as teenagers.
ReplyDeleteYes I think it will be a great idea to be able to teach this knowledge to our kids. It's this financial knowledge that will help your kids build the foundation to be financial free.
DeleteVery well written article on compound interest Hansen! I am very lucky to have learnt about compound interest a couple of years ago when I was in my mid twenties! This gives me plenty of time to let my money grow and compound.
ReplyDeleteHey Money Grower, Thanks for visiting my blog and taking your time to read my article. Yes you are lucky to start in your twenties. I'm also very fortunate to be able to learn this simple but valuable knowledge from my brother at the age of eighteen. Hopefully I can use this knowledge to compound my investment and be financially free in my thirties.
DeleteYes yes..compound interests are not magical but so so essential.. Point driven home.. :)
ReplyDeleteThanks for reading my article Jonny Pean. Yes I totally agree with you, it's essential!
DeleteGreat illustration about the power of compounding. Thankfully I found out about compounding at the relatively early age of 23. I believe that the time horizon that I have will be my biggest asset and I can't wait to see how much the money I am investing now will turn into in 20 - 30 years
ReplyDeleteHey Money Grower UK, Thanks for taking your time to visit my blog and reading my article. Yes you start at an early age, you will meet your financial freedom sometime soon in the future.
DeleteHi Bun,
ReplyDeleteStarting early is very important. I am teaching my kids to invest now with their extra money. Another point is to never tap that money. Leave it alone and let it grow.
Cheers,
DFG
Hey Dividend Family Guy, I want to say thank you for visiting my blog and taking your time to read my article. Yes that's my plan with this portfolio. I am saving and compounding it for my future.
DeleteCompounding is one of the reason I got started in dividend investing and one of the reasons why I'm kicking myself for not having started when I was younger. To all the young folks out there, especially in your 20s: there is no time like the present!
ReplyDeleteGreat article Hansen.
Thanks for visiting my blog Glen. Yes it's better to start early than to start later!
DeleteHi there,
ReplyDeleteWell, I truly enjoyed studying it. This information provided by you is very helpful for good planning. It’s very simple to find out any matter on web as compared to books, as I found this post at this website.
Hi Mac, thanks for visiting my blog and taking your time to read my article. I hope the content that I provide can give a better insight.
DeleteHi,
ReplyDeleteIt’s very simple to find out any matter on web as compared to books, as I found this post at this website.
I am not sure where you are getting your information, but great topic. I needs to spend some time learning much more or understanding more. Thanks for excellent information I was looking for this info for my mission.
Hi CBD, thanks for visiting my blog and taking your time to read my article. I hope the content that I provide can give a better insight.
DeleteHii,
ReplyDeleteI like the helpful information you provide in your articles. I’ll bookmark your weblog and check again here regularly. I am quite sure I will learn a lot of new stuff right here! Best of luck for the next!
Hi Flora, thanks for visiting my blog and taking your time to read my article. I hope the content that I provide can give a better insight.
DeleteSounds like insurance investment to me...
ReplyDeleteuniverse of investing cash is essentially a business game focused on clueless financial backers (over 90% of the investing public). I once read that NOW is consistently the hardest opportunity to put away cash. Saham
ReplyDeleteThe United Kingdom hits a 5.7% product trade deficiency as a percent of GDP; India a 6.1%, Hong Kong a 15% and United Arab Emirates a 18%. India has developed more than 6% each year on normal in the course of the last 25 years, and Hong Kong and UAE somewhat better than 4%. Fortune best cryptocurrency to invest
ReplyDeleteIt is essential to have an excellent know-how of every clause, as a poorly written settlement could make you run into legal responsibility issues.Alternative Funding Group
ReplyDeleteConfounded at this point? Symphonious trading is perplexing and requires a great deal of time and practice to dominate, yet it very well may be extraordinary compared to other trading frameworks since it offers high prize versus hazard proportions and it is extremely adaptable. icoshock top cryptocurrency to invest
ReplyDeleteEach time the trader benefits, you will benefit and each time he loses you will lose. The framework permits you to benefit essentially by not limiting you to a solitary record; you can connect it to various traders' records. Profit Revolution Bitcoin Review 2021
ReplyDeleteThe drawback to these frameworks is numerous fresher brokers observe this way to deal with trading dull and see it as older style. It comes up short on style and fervor of marker driven framework.buy viewers for twitch
ReplyDeleteThese frameworks might function admirably under specific economic situations, yet the market is an animal of numerous temperaments and not many frameworks function admirably in all market circumstances. bestearobots.com
ReplyDelete