The Power of Compounding

Last week I advised that you take the time NOW to save for that rainy day.?Make the hard choices now.?Choose the hard way instead of having it thrust upon you later on.?Why is it so important to start NOW??Why does waiting hurt?

One of my readers advised that after looking at his magic number he felt depressed.?His magic number for the entire month was just over $500.?I can hear him asking: how can I possibly save for retirement when my magic number is so low??How can I save when I am struggling to pay my bills??When do I really have to start saving?

Suze Orman, the well-known personal finance guru advises, and I agree, that the time to start is right now.?It doesn’t matter how old you are.?This is because time is the most important factor in the growth of your money.?Suze notes that the more time your money is given to grow, the more money you will have when you retire, and the earliest money you contribute to your retirement grows the most.?Planning and investing for your future is the best way to love yourself.?And remember if you cannot love yourself, you cannot love others.?START NOW!?Make the sacrifice, start small, but start.

Whether you are 25 or 55, it’s never too late to start saving for retirement.?Obviously, the sooner you start, the better off you’re likely to be during your retirement years.?Time is the powerhouse that turns dollars into fortunes.?At the root of its power is the concept of compound interest, a powerful financial tool available to everyone—what Albert Einstein called the “eighth wonder of the world”.?

As Morgan Housel advises in his book "The Psychology of Money":

“More than 2,000 books are dedicated to how Warren Buffett built his fortune. Many of them are wonderful. But few pay enough attention to the simplest fact: Buffett’s fortune isn’t due to just being a good investor, but being a good investor since he was literally a child.?

As I write this Warren Buffett’s net worth is $84.5 billion. Of that, $84.2 billion was accumulated after his 50th birthday. $81.5 billion came after he qualified for Social Security, in his mid-60s.

Warren Buffett is a phenomenal investor. But you miss a key point if you attach all of his success to investing acumen. The real key to his success is that he’s been a phenomenal investor for three quarters of a century. Had he started investing in his 30s and retired in his 60s, few people would have ever heard of him. ...

Effectively all of Warren Buffett’s financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years.

His skill is investing, but his secret is time. That’s how compounding works.”

Compound Interest

Interest makes money grow, and compound interest makes it grow fastest of all.?Let me explain how: "Simple" interest is the basic interest charged on any amount of money loaned.?If you lend $10,000 at 10% simple interest per year, each year you will receive $1,000 back on your money.?At the end of five years, you will still have your original $10,000 plus 5 yearly interest installments of $1,000 each, for a grand total of $15,000.

Compound Interest pays interest-on-the-interest as well as on the principal.?Interest normally accrues monthly, quarterly or yearly and, as it accrues, it is added to the principal and future interest is computed on this total.?Therefore, you receive interest not only on your principal, but on previous interest earned as well.

$10,000 lent at 10% compounded annual interest yields $16,105 after 5 years, a bonus of $1,105 over simple interest.?A mere $1,000 invested annually at 10% compounded interest over 30 years yields an impressive $180,943!?Compounding interest has an attractive effect on the value of money.?It makes money worth more tomorrow than it is today.

Assume you want to save $1,000,000 by the time you turn 60 and you can invest in a retirement account which earns an average annual return of 5%. ?If you start saving when you are 20 years old, you would have to contribute $655.30 a month – a total of $314,544 over 40 years – to be a millionaire by the time you hit 60. ?If you waited until you were 40, your monthly contribution would bump up to $2,432.89 – a total of $583,894 over 20 years. Wait until 50 and you’d have to come up with $6,439.88 each month – equal to $772,786 over the 10 years. ?The sooner you start, the easier it is to reach your long-term financial goals. You will need to save less each month, and contribute less overall, to reach the same goal in the future.

Let’s look at another example.?You invest $500 per month earning interest at an annual rate of 5% which is credited to your account monthly.?You do this for 20 years.?In the first year you will earn $165.?In the second year you will earn $480.?This is because you are earning interest on your contributions AND the interest credited to your account every month.?By year 15 you will be earning as much as your annual contribution if you are disciplined and contribute every month.?Your contribution of $120,000 over the 20 years will have grown to over $206,000, over 14% higher than the $180,250 your contribution would have grown to with simple interest, a difference of $25,750.

So, what are you waiting on??Start saving NOW!!!

Cheers, Nigel?

Nigel Romano, Partner, Moore Trinidad & Tobago, Chartered Accountants