Budgeting Basics: Investing and The Power of Compound Interest

by mzumtaylor on January 8, 2011

in Budgeting,Investing,Saving

Compound interest is one of my favorite things about investing.

Why Compound Interest is Cool

It seems awesome to me that that you can put $1,000 in an investment account every year for ten years, and get and average of 8% interest, at the end of that 10 years, you’ll have not $10,000, but $17,800. (Check out the compound interest calculator at MoneyChimp.com)

So, to give you a more detailed example: if you start saving $100 a month when you’re twenty ($1,200 a month), and invest it in an account that earns 8%, compounded annually, and you do this for ten years, by the time you’re thirty, you’ll have added $12,000 of your own money, and you would have a total of $21,365. And then, if you didn’t touch it again until you went to retire at 65, you’d have $315,893.

And if you saved for twenty years (personal investment of $24,000), at the end of those twenty years, you’d have $64,900.65. Then, if you left it alone until you were 65, you’d end up with $959,578, or almost one million dollars.

Why Compound Interest Benefits the Young

Compound interest is most valuable over a long period of time. Because that’s true, the more time you have, the more money you can earn through compound interest.

Let’s say there’s a young woman named, Amber, and she followed the guidelines above, and saved $100 a month from the age of 20 to the age of 40, and earned 8% interest, compounded annually. She’d be a near millionaire by the time she was ready to retire. Bully for Amber. 😀

Now, let’s say Amber’s friend, Brenda, didn’t quite follow the same guidelines. Instead, she saved $100 a month from the age of 30 to the age of 50, also with 8% interest, compounded annually.

They’ve both invested the same amount of money ($24,000), and at the end of the 20 years have the same amount of money to show for it ($64,900), but Brenda’s will have less time to grow after that. By the time she reaches 65, having never touched her $65K again, she will only have $205,875.

Brenda will have over $750,000 less than Amber at age 65. A difference of 3/4 of a million, just by starting 10 year earlier.

You may think I’m a huge dork, but I find this stuff fascinating.

Okay, But What Do I Do With This Information

Remember, last time, how we talked about saving 10% of everything you earn? Staying out of debt is a good reason to have savings, but taking advantage of compound interest by investing is another reason.

Or, to put it more simply:

    Save early, save often.
    Invest early, invest often.

Whatever else you’re saving your money for, it’s a good idea to take a chunk of it, and invest it somewhere you can earn 7-10% interest, on average. Common wisdom has 8% as a good average annual return on investment. Who knows what the future might hold, but that has been the trend.

But where are all the specifics?

You might be wondering why this information is so general, and you’d be right to. I’m sorry to say that I don’t have as much experience with investing as I would like, because my husband and I still have debts that we’re trying to pay off.

There are, as you might imagine, various opinions on the matter, but many people argue that you should pay off your debts before you start to invest, so you’re not stretching your resources too thin.

I’m not 100% where I fall in this debate. I’m personally frustrated by the fact that time is slipping away and we’re not investing hardly anything (we’re putting money into my husband’s 401(k), but that’s it), but at the same time, the logic behind paying off debt before investing makes a lot of sense to me.

So, for the moment, the “Pay off your debts first” camp has my vote. I’ll let you know if that changes.

Where To Go From Here

There are countless books and blogs out there on how to get started investing. I know Ramit Sethi of iwillteachyoutoberich.com has some good advice, as does Trent Hamm at TheSimpleDollar.com and the team over at GetRichSlowly.com

I read a bunch of books about investing a few years ago, when I first dove into personal finance to teach myself, but they weren’t as relevant to me at the time, so I don’t remember which were good and worth recommending. I’ll work on that for you.

Good luck, and, as always, if you have any questions, don’t hesitate to contact me.

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{ 2 comments… read them below or add one }

Troy July 7, 2011 at 10:10 am

Hi, I love reading your posts, however I do have one question…. Where can I find somewhere that will pay 8% compound interest? that seems like a little much to me.

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mzumtaylor July 20, 2011 at 9:51 am

There is some debate over whether the “average” stock market return of 8-10% is an accurate figure off of which to base investment calculations. The problem lies in the definition of “average.” See this explanation at http://www.moneychip.com for details, as well as a calculator showing “average” stock market returns and the compound annual growth rate (CAGR), which is the more accurate number.

This is what I know: over the last fifty years (according the to aforementioned calculator), the stock market has had a CAGR of 9.56%. If, in 1960, you had invested $1.00 an index fund that was directly tied to the S&P 500, you would now have $105.20. The most significant trend, as moneychimp.com points out, “Over the very long run, the stock market has had an inflation-adjusted annualized return rate of between six and seven percent.”

So I was off by +/-1%, but for rough math, that’s not terrible.

(I am obligated to note that past market performance is not indicative of future success, but the general trend of the stock market since it’s inception has been up. The examples given are only for explanatory purposes, and do not constitute investment advice.)

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