You might have it in your mind that once you start making more money later in your career, it is then that you can start saving and investing money. This of course, is a very dangerous belief. Why? Because of the power of compounding interest.
There’s an urban legend that Einstein once said, “compound interest is the most powerful force in the universe”. Now, whether or not Einstein actually said this is irrelevant because it is indeed, a powerful concept that everybody trying to get ahead financially must understand. Scratch that, I would go even further – a deep understanding of compound interest is required if you want to be financially secure.
Compound interest gets thrown around by financial advisers and gurus often, but they fail to explain the concept that is easy to understand. Compound interest is simply the interest calculated on your initial savings plus interest calculated on accumulated interest from prior periods. Or as Investopedia.com states it as, “interest on interest”. The big benefit of compound interest happens over a long period of time, which is why it’s important for you to budget a large chunk of your pay to go towards your savings and investing bucket, and not get up into the day-to-day fluctuations of your portfolio.
Let me give an example that will showcase the importance of saving and investing early in your career. In this example, “Johnny“ invests $7,500 per year from 25 years old until 45 years old. He then never contributes a single dime to his retirement account for the rest of his life. At the age of 45, Johnny will have $309,365* in his retirement account. Now, fast forward 20 years when Johnny is 65 years old, (again, assuming no contributions to this account from 45-65 years old) he will have a staggering $1,197,144*.
Now let’s take a look at Johnny’s friend Jane. Jane had it in her mind that saving was not important in her 20s and 30s. Jane decided that spending money on fancy cocktails at the new trendy bar that just opened was much more important. Jane was living for today and not planning for tomorrow. Finally at 45 years old, she realized she needed to get serious about her retirement and budgeted for $10,000 per year to put into an investment account. When Jane is 65 years old, she will have $412,486* in savings. Take a look at the difference in net worth between Johnny and Jane in the chart below:
Because Jane decided to wait until she was 45 years old to save and invest, she ended up with only 1/3 of what Johnny was able to accumulate, or an $800k difference. This is despite having saved for the exact amount of years (20), AND even saving $2,500 more than Johnny every year. Why? The power of compound interest.
*Account balances are calculated under the assumption of an after-tax rate of return of 7%