by Edwin Ivanauskas | Tags: Personal Finance, Investing, Banking, Loans

We always hear about compound interest and it’s “power” to make you wealthy. Whether you’ve heard it from Dave Ramsey, from an online community or just from relatives, you likely know about this mythical power.

But no one really takes the time to explain why compound interest is so great or explain to you the mechanics that make it that way. I’ll start by using Dave Ramsey’s example of Ben and Arthur. Ben started saving $2,000 a year from age 19 to 26. In contrast, Arthur began saving $2,000 from age 27 until retirement at 65. Both are getting a 12% return every year. (See this example here)

That’s pretty impressive, saving only $16,000 early in your life instead of $76,000 later gives you $756,830 more for retirement! But this is using a 12% return, which is unrealistic. Let’s change this to a more realistic 7.5% return instead of living in a fantasy land. Here’s what we get:

Using this more realistic rate of return somewhat hamper’s the “power” of compound interest that Dave Ramsey is trying to display. Nonetheless an investment of $16,000 is yielding $376,994 while the $76,000 is yielding $452,513. For Ben that’s an increase of 2,256.21% and for Arthur it’s an increase of 495.41%.

Even when we use realistic numbers, there’s something to this compound interest thing. So what is it that makes such a dramatic difference? This money is accumulated through your contributions, which early into your saving is from actually putting cash into your accounts. Here are some snippets from my excel sheet:

What I want to point out is that the contribution from interest increases as the principal increases. The first year of savings, interest is only contributing $150 compared to the $2,000 of cash contributed. But as we get to the 6th year, interest on the principal is already contributing $1,087, more than half, compared to the same $2,000 cash contribution. If you were getting 0% interest, this would be like increasing your cash contribution to $3,087 and further increasing it every single year. Let’s take a look at the very important transition point where the contributions from interest surpass the contributions from cash.

For Ben, his contributions from interest surpass his cash contributions on the 12th year of his investments (He stopped cash contributions altogether on his 8th year). For Arthur, it took only 10 years from when he began investing for this to happen, it was quicker because he continued his contributions (18 years after Ben started investing). Due to Ben starting his contributions early, he was able to reach this point 6 years before Arthur did.

Because of this huge head start, Arthur took until age 48 just to catch up to the total that Ben has been able to accumulate (that’s 22 years after he started investing!). By contributing 16,000 before Arthur began any contributions, Ben was able to contribute $110,253 in savings while Arthur had to contribute $44,000 to save up $112,056.

So what would happen if we had a third brother who has been saving $2,000 in cash every single year from age 19 to 65 enter the scene?

The lesson here is that the earlier you can start contributing money, the sooner your interest contributions can surpass your cash contributions. And the sooner that happens, the more money you will have in the end for each dollar you invested in the beginning.

The Power of Compound Interest

The power of compound interest is that at a certain point, the contributions to your total savings from just your interest will surpass the contributions you make with cash. At this point you are able to passively increase your savings far more than you could on your own

 

Compound interest is powerful but people must decide how to make use of that power without sacrificing everything else in their lives. It would be possible to live as frugally as one can imagine and store a huge amount of money in savings, but is that a good option?

Compound Interest Run Wild

We have two sisters, Jane and Jill. They both earn they exact same amount of money, let’s say $40,000 a year.

Jane is the most frugal person you can imagine; somehow she manages to live off of only $1000 a month. She bought a very cheap house and car, eats on the cheap and has nearly no expenses. Because of this she’s able to invest $27,999.96 every single year from age 19 to 65. She ends up with a total of $11,613,077 in her retirement account.

On the other hand we have Jill. She is an average person who lives by the rule of saving 15% of her income for retirement. This adds up to $6,000 a year. Jill bought a house within her means and lives responsibly yet buys the things she enjoys in life. By the time she hits age 65, Jill has a total of $2,488,520 in her account

That frugality surely paid off for Jane, she has over $9 million more than her sister for retirement. Using the rule that you can live off of 80% of your pre-retirement income and imputing these numbers into any calculator, we see that both sisters can afford to withdraw far more per year than their $40,000 income.

 

So what has Jane really gained from living so frugally her whole life? With $11.6 million to her name, she can live a very good lifestyle and / or leave it for her children. Is 20 years of a very good living or a hefty estate a good trade-off for 46 years of an extremely frugal life, and could Jane even make such a dramatic switch from pinching every penning?

Jill managed to have a very good life where she was able to responsibly save for retirement while being able to afford to do the things she enjoys. She doesn’t have near the amount for retirement that Jane has, but $2.5 million can definitely provide a comfortable life.

These numbers show us that if you are responsible, you can have a very good retirement and still enjoy the things you love. Even if you aren’t able to invest 15% of your income from age 19 to 65, there is time to fix yourself up for retirement. The rule of thumb is that you need about 12 times your income in retirement, that’s $480,000 for these sisters. Jill, who saved less than Jane, has 62 times her annual income!

Don’t Buy Into the Frugality Hype

You don’t need to always follow the guidance of people who tell you that if only you stopped drinking that cup of coffee every day or that you should always be driving a used clunker for a car. The key to having a comfortable retirement is balancing the savings needs with your life. If you enjoy cars, buy an expensive car, as long as you don’t jeopardize your retirement savings for it.

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Comments (7) [+] add comment

Stephan

May 19, 2010 at 10:31am

great post, love the simple explanation. Obvisouly, the rates of return are very variable, so i dont really trust the graphs that show what you could make if you did so and so. I would argue that even 7.5% is a reach because of the massive drops the market has seen over the past 30 years at pretty regular intervals. Preferred Financial Services

Darrell

May 19, 2010 at 12:04pm

Lots of great insight, many things that are very intuitive that I just hadn't ever put together before. For instance your example of Jane, she spends her entire life pinching pennies and living extremely frugal... this lifestyle is embedded in her, and when she retires she isn't going to just bounce out of it and start spending. She will continue to pinch pennies and live extremely frugal. In the end it just comes down to a balanced lifestyle and living within your means. Great article that challenges theories and assumptions made in the past.

Edwin | Finantage

May 19, 2010 at 1:19pm

Stephan - As you point out, it is very important to note that the info here uses averages. Averages in the markets just does not reflect reality. It is only useful as a point of comparison, not as a tool for modeling actual savings. Darrell - I see stories all the time (well not all the time but often enough) about the old lady who lived so frugally, never went on vacations or anything, and had millions of dollars at death with no kids to pass it to. What kind of life is that? In my view, a poor one.

utiliguy

May 22, 2010 at 11:41pm

Great illustration of how compound interest works. I like your examples and detailed explanations. In this environment, though, I feel we'd lucky to get even 7.5% return. These days even long term treasuries are below 4%.

Edwin | Finantage

May 23, 2010 at 12:22am

Hey utiliguy, thanks for the comment. There is definitely a lot more to the real world application of these examples. I ignore inflation, wage increases, actual returns and risk. I've tried to simplify it as much as possible to make an easy comparison between the different situations.

Rob Bennett

May 25, 2010 at 3:54am

The way that I think about it is that the cup of coffee can provide compounding returns too. You choose the cup of coffee for a reason -- there must be some benefit there. Maybe you are networking during your coffee time. One of the people you get to know better will end up getting you a job when you really need one and the financial benefits will extend forward for many years. Maybe taking a break for coffee relaxes you enough so that you don't blow up at your boss and pay a financial price for the intemperate decision. Maybe you have a talk with your spouse over coffee and it leads you to buying a better house or moving your kids to a better school. There really is a benefit to compounding. But some make it sound like compounding only works for money not spent. Money spent provides benefits and those benefits compound too. Rob

Edwin | Finantage

May 25, 2010 at 3:18pm

Interesting viewpoint Rob, the idea is that it's not always good to focus purely on being as frugal as possible to squeeze a few extra dollars out of the money in your accounts. People are far better off living a normal life and doing normal things which in themselves can, in a compounding way, lead to a better life that could or could not be based on finances.

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