Tuesday, 10 May 2016

Compound Interest: The Reason to Start Early

How Compound Interest Works
You've probably heard (over and over again) that you should start saving for retirement as early as possible but do you actually know why? It's a little thing called compounding interest, and it will make a BIG difference in the amount of money you can save up in the long run. Let's take a look at why this is the case. 

The basic theory behind compounding is that the more dollars you have available the more growth can happen, as long you are getting positive returns. Why is this? Well, as long as your funds are growing there will be more of them to move into the next year, and that means there are more dollars for interest to do its work on. 

Let's take a look at this in action, we're going to start off with an easy example that uses only a one time deposit. The formulas below look scary but once you break it down they make a lot of sense, I promise. 

The formula we're going to work with for this first example looks like this: 

A = future value
P = principal (initial investment)
r = rate of return
n = number of compounding periods
t = term (number of years invested)

Now let's use some numbers...let's say you make a deposit of $10,000 and want to know how much it will be worth in 30 years (without any further deposits). We're going to assume a 5% rate of return and monthly compounding, which means you would get paid your return 12 times a year (12 periods). 

Once you get that all input you will get a result of A = $44,677.44. Over four times your original investment...not too bad hey?

Most people don't save for retirement this way, though, it's much more common to make small deposits more frequently...so now we're going to complicate things and look at making monthly deposits. Here's the formula we'll be using for multiple deposits: 

And now time to input those numbers; this time we're going to make $200 monthly deposits ($2400/year) for 30 years with a rate of return of 5% and monthly compounding. Without compounding this would be a total investment of $72,000 ($200/month for 30 years). 

This formula looks a little crazy, but once you get it all figured out the total future value will be $167,145.28. It's not as significant an increase as in the first example because you start out with a smaller amount but your money still more than doubles in that period so....worth it! 

Ok, last one. We're using the exact same formula here but we're decreased the number of years your save from 30 to 15. To really highlight the importance of starting early I am even increasing the total investment amount of $72,000 the same, but that means you have to contribute $400/month instead of $200. 
After crunching those amended numbers you get a result of $107,361.06. So even though you have contributed the same amount of money, because you started earlier you net out an additional $59,784.22 thanks to compound interest. Pretty convincing argument hey? You get to decrease the amount you have to contribute each month and you end up with an extra $60k. 

How Compound Interest Works


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