February 2024
Albert Einstein considered compound interest the "8th Wonder of the World." It is a powerful force for growing savings and grows more powerful over time. Interest is paid on the initial principal (the money you put in) plus the earnings, as long as they are not withdrawn, that accumulate over time. Simply stated by Benjamin Franklin: "Money makes money. And the money that money makes, makes more money."
Someday someone may give you this choice. Do you want to be given a million dollars or instead a penny. If you choose the penny, the next day you will be given 2 pennies. The following day 4 pennies and so on doubling the amount for the next 27 days.
As shown in the table, the wise choice would be to take the penny. Around day 20 the balance begins to really pick up and at the end of the thirty days you would have over 5.3 million dollars. An investment return of 100% every day is unlikely, but this example of compounding demonstrates earnings on earnings.
You Want Time On Your Side
The following describes two long term saving plans, but the benefits of compounding apply to any time period.
Over their careers siblings A and B took different approaches to saving for retirement. In the first ten years A deposited $10,000 every year into a ROTH 401k. After that she added nothing more to the account. In those first ten years B saved nothing, but seeing how well A was doing he decided to open his own ROTH. Every year for the next 30 years he added $10,000. So, A put aside $100,000 and B $300,000. Who will be the more successful saver?
Surprisingly, A will have 20% more than B, roughly $1.2 million to $1 million. A needed to be determined to be sure to put away $10,000 every year for ten years. B will need to be even more determined to save $10,000 every year for thirty years. A lesson here is that the compounding of savings is not only economically beneficial but it’s easier than saving money. Do you think A or B is more likely to miss or delay a deposit?
Both accounts earned 7% each year. ROTH’s grow tax free, so income taxes are not an issue. Saving $833 per month is not unrealistic, certainly not for everyone, but for many people. Deposits into a ROTH are with after-tax dollars, which makes it tougher than saving in a tax deferred account.
The siblings are just starting out. Someday parents, C and D, will expect them to get their own places. Is a mortgage a good idea? Most likely yes. Renting is ok for awhile, but in the long term mortgages build equity and are therefore a form of stealth savings. People don’t miss mortgage payments, same as they wouldn’t miss paying rent. Mortgages payments add to savings without even thinking about it.
Debt involves compounding as well. Again from Einstein: “A person who understands compounding, earns it, a person who doesn’t pays it." To appreciate the impact of compounding on debt, take a look at your loan’s amortization schedule. Especially in the early years you will be amazed how much interest you can save by doubling up on principal payments.
During that 40 year period A & B may have a choice between a ROTH deposit or making extra mortgage payments. That decision is dependent on circumstances, goals, etc. which for A and B may vary significantly. They would be wise to consult E, a financial advisor. Fortunately unpaid school loans are not a problem for them due to generous 529 education plan contributions from grandparents F, G, H and I. The 529 accounts grew compounded and tax free as well since they were used to pay for education.