How to Harness The Power of Compound Interest and Accelerate Your Journey to FIRE
Legend has it that when asked what mankind’s greatest invention was, Albert Einstein simply replied: “Compound Interest.”
In addition, he’s also been quoted as saying that compound interest is the “eighth wonder of the world.”
I want to help explain the true power of compound interest, how you can take advantage of it, and what it could mean for your journey to financial independence and early retirement. But before we get there, let’s first understand what compound interest is.
What is compound interest?
There is no better way to explain compound interest than this quote by Benjamin Franklin:
“Money makes money. And the money that money makes, makes money.”
Here’s an example:
Imagine you start with $100, and you have that money invested in an index fund full of different stocks. Let’s say your index fund returns an average of 7% per year.
So, at the end of the first year, your original $100 worth of index funds is now valued at $107.
Here’s where the magic happens — in year two, you gain another 7%, but instead of gaining 7% of $100, which would be another $7, you gain 7% of $107, which comes out to an additional $7.49.
While this might seem like a trivial difference initially, the true power of compound interest really starts to shine over long periods. Consider that using this same example, after 30 years of compounding, your initial $100 is worth a whopping $761 compared to just $310 if your money was not compounding.
That’s more than doubling your end result with the power of compound interest! Add a couple of zeros to this calculation, and you can quickly see why this is the eighth wonder of the world.
To help you visualize this example, here is a nice graphic from the Visual Capitalist (with a couple more zeros) to highlight the power of compound interest.
As you can see, over time, the interest and the interest earned on the interest start to add up, accelerating your journey to FIRE.
Are you really earning “interest”?
I think it’s worth explaining that when people say compound “interest,” it doesn’t always mean that you are actually earning “interest”.
In the previous example, you purchased an index fund that appreciated over time — you didn’t earn any “interest” on your index fund. However, as it appreciated by 7% each year, that growth of 7% continued on the new, higher-value each year. So now, let’s explore just how much of a difference compounding can make in your financial situation.
The power of compound interest.
The true power of compound interest shows itself over time. To help understand the relationship between time and compounding, let’s look at another example from the Visual Capitalist.
In this example, you have Jessica on the left and Newman on the right.
Jessica starts saving ten years before Newman at the age of 25.
Newman waits until he is 35 to start investing, BUT he invests twice as much as Jessica every year from when he begins to when they both turn 65. Any bets on who has more money when it is all said and done?
If you guessed Jessica, then you are CORRECT!
Despite having saved only half the amount that Newman did, Jessica still ends up with a larger investment balance simply because she got started ten years earlier and put compound interest to work on her behalf!
The earlier you start saving and investing, the more powerful compound interest becomes.
So all that being said, what can you do to start taking advantage of the power of compound interest?
How to harness the power of compound interest?
This is as simple as it gets: start saving and investing TODAY.
The sooner you start, the easier it is. Often, one of the biggest areas that people fail with personal finance is thinking that they have to have everything perfectly figured out before they get started.
This means they end up waiting a lot longer than they should to start investing. So my challenge to you is to figure out what amount you could set aside right now to get started investing and just make it happen!
Realize that the best time to start investing was yesterday, and the second-best time is today. By getting started now, you can harness the incredible power of compound interest and put your money to work on your behalf.
Think about this, for every ten years that you wait to start investing, you have to save nearly twice as much money just to get to the same result. So put another way, the sooner you start, the less you need to save to reach the same level of wealth.
Here is another graphic from the Visual Capitalist to continue to drive home the point. This shows how much money you would need to invest to end up with 1 million dollars at the end of each period.
The results are staggering. If you want to be a millionaire in 15 years, you need to invest $33k PER YEAR. But if you start when you are 20 years old and want to be a millionaire by 65, you need only invest $3k per year!
So now that you have an understanding of what compound interest is, the true power, and how to harness it, let’s talk a bit about what it could mean for your financial situation.
What compound interest can do for your financial situation.
Armed with the knowledge of compounding, you start to see why it can be so powerful to start saving and investing while you are young.
Referencing the graphic above, if you have 50 years to save and invest, you can become a millionaire by only investing $107,500.
Contrast that with someone who delays saving for retirement and only has 20 years to save — they would need to invest $419,000 to reach that same $1 million mark. Plain and simple: start early, and the money will do the work for you. Start later, and you will need to do a lot of the work to get there.
Putting it all together.
To sum it all up, compound interest is the interest you earn on the interest that you have earned.
It is a multiplying force that will help propel you to financial independence and put your money to work on your behalf.
By understanding the relationship between compound interest and time, you can see the real value in getting started young with your savings and investments. By delaying saving and investing, you lose some of the power of compounding, resulting in you having to put forth more effort rather than letting your money work on your behalf.
Remember, the best time to start saving was yesterday, and the second-best time is today. So do not delay, and do not hesitate to share this with any young people in your life that are wondering if they should start investing now or if they should wait.
