Learn The Power of Compound Interest And Use It
Posted on November 2, 2007
Last week I wrote about how we are entering the most opportune time in 50 years to start investing in real estate and building a portfolio of income producing properties. Although the weak sales market is creating some great opportunities to invest, real estate is not for everyone. Young people who have yet to establish credit and who have little or no savings will find it especially difficult to buy real estate. Fortunately, there are other alternatives to help them get started and prepare them for future opportunities. Young people have the greatest asset of all to invest, which is time.
If you can only save a few dollars each week, these savings can show remarkable growth even when conservatively invested at a small rate of return. Money invested at a 6% annual rate of return will double every 12 years. Invested at a 10% rate of return, which is about the average compounded return stocks have shown over the past 80 years, it will double every 7.2 years. Now let’s look at the advantage time provides young people.
If you start at age 20, and put $20 a week into a tax free retirement account, and do this for 5 years, your total contribution will be $5,200. Disregarding any interest this money earns during that first five years, let’s look at what compounding interest on that five year investment could mean if you never added another dollar to it. If it earns an average of 10% per year, it will double approximately five and one half times by the time you reach age 65. The first time it doubles you will be just over 32 years old and it will be worth $10,400. Before you reach 40, it will double again to $20,800. At about age 47 it will be worth $41,600. Just before you turn 54 you nest egg will double again to $83,200, but the best is yet to come. At age 61 it will be worth $166,400 and by age 65, when you are ready to retire, that original $5,200 will have become worth about a quarter of a million dollars.
When you compare this to what would happen if you waited until you are age 40 to start saving for retirement, it’s easy to see why I say young people have the greatest asset of all, which is time. If you wait until you are 40 to get started, you would have to deposit $4,000 per year, every year, for the next 25 years in order to have approximately the same amount of retirement funds as the young person who deposited just $5,200 by age 25 and let it grow until retirement.
We all know that no matter what your age, while you’re working you should plan for retirement, but the earlier you start, the better your retirement will be and it doesn’t mean you have to wait until you’re 65 to retire. My goal was to retire at age 50. It was a goal I wrote down at age 20 and carried in my wallet throughout my life. This goal kept me focused and investing from an early age and enabled me to reach the goal right on time. That didn’t mean I quit working at age 50. Retirement means different things to different people. For me, it meant that each day when I got up I had the luxury of being able to do what I wanted, not what I had to do to earn a living.
I realize how difficult it is to forego buying things you want but really don’t need in order to save, but that’s what it takes to secure your future and ultimately be able to have more in the long term. The power of compounding interest becomes more powerful the longer time it has to work. $5,200, invested by age 25 at an average rate of return of 10% and allowed to grow over a working lifetime can become a quarter million dollar nest egg, but the same amount set aside at age 40 will only grow to a little over $30,000 by age 65.
Obviously this message is directed at young people, but for parents or grandparents who would like to do something great for a child, think about this; a $2,000 gift at birth invested at a 10% average return could be worth over half a million dollars by the time the child reaches age 65. Yes, compounding interest is amazingly powerful the longer it is allowed to work.
Here’s a tip! If you’re just starting your working career, the best habit you can develop is paying yourself first before you buy anything else. You may only be able to save $5 or $10 per paycheck in the beginning, but once you develop the habit it will become progressively easier to increase this amount as your salary grows. Saving and investing can become a habit as addictive as drugs or alcohol, but it’s a habit that will enhance your life not ruin it. By the same token, overspending and going in debt can also become a habit and might well make it impossible for you to save.
For young people just getting started in life, the temptation to spend everything you make and worry about retirement later is extremely great. By following this tip and paying yourself first, you will soon adapt your standard of living so that you don’t even miss the money you are saving. If you’re already living a lifestyle that takes everything you make to pay the bills, you need to reevaluate your priorities. You won’t feel the ultimate cost of failing to save until later in life and by then it will be too late for time to be on your side.
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