Every $1,000 you save today could be worth $64,000 at retirement. Although I’m certainly not immune to typos, the previous sentence doesn’t have any. I double checked.
You have likely heard of compound interest before. The general idea is this: you earn interest on your previous years interest; so each year, you progressively earn more and more interest.
If you have $1,000 and earn 10% on it [$1,000 x .1 = $100], after a year, you’d have $1,100. [The 10% is just an estimate based on the long term rate of return from the U.S. stock market. Think: basic, entry level 401k investment options such as an S&P 500 Index Fund that your HR department should be able to show you. In reality, annual rates of return can vary quite a bit. As of Nov 2019, the market has had a historically long period of strong performance. This 10% rate of return is not guaranteed but is held constant in this example for illustration purposes, and, is pretty close to long term historical performance. Go here for more info on the S&P 500 if it sounds intimidating]:
https://bote.finance.blog/2019/11/25/the-market-ive-heard-of-it/
This $1,100 is the initial investment of $1,000 plus the $100 of interest. Simple, right? Now it gets interesting… During year two, you still earn 10%, but now it’s 10% of the new amount which is $1,100, not just the initial investment of $1,000. So, at the end of year two, you will have $1,210. Here’s how. You started year two with $1,100 then you add in your 10% interest on that amount. [$1,100 + ($1,100 x .1)]= [$1,100 + $110] = $1,210. It is important to recognize that you do not just take the year one interest of $100 and multiply it by two, which would be $200. That extra $10 is the key to what is called exponential growth. Although small initially, the growth of compounding interest increases with each period (year, month, decade, etc). After 10 years of 10% growth with an initial investment of $1,000, you’d have $2,593. You do NOT just take your 10% gain in year one (which was: 10% x $1,000 = $100) and then multiply it by 10 years and get $2,000. Compound interest accounts for the extra $593.74. Congratulations!
Some examples to encourage you:
You are 35 years old and have $5,000 today in a S&P 500 index fund (This is what I mentioned above. Don’t let the name scare you). We will assume that it will earn 10% per year (again, not guaranteed but historically, this is pretty close). You plan to retire in 30 years at 65 and you don’t put in another dime. At 65, you’ll have $87,247.01. This is more than 17 times your original value of $5,000.
Keep in mind, the earlier you put money in, the more time it has to accumulate via compound interest. Also keep in mind that the above example assumes that you started with $5,000 and never added to it. Another way to make your total grow is to periodically add to your growing balance. Let’s say you save your tax returns and add $1,000 to your account every year until you are 65. The total you would have at retirement would be $251,741.03, more than 50 times your starting value.
A few more examples based on the 35 year old mentioned above who plans to retire at 65:
- You start with $10,000 –> By retirement at 65: $174,494.02
- You start with $15,000 –> By retirement at 65: $261,741.03
- You start with $50,000 –> By retirement at 65: $872,470.11
Now, let’s see how our 35 year old does after adding $1,000 per year in the above examples.
- You start with $10,000 –> By retirement at 65 (+$1,000/year): $338,988.05
- You start with $15,000 –> By retirement at 65: (+$1,000/year): $426,235.06
- You start with $50,000 –> By retirement at 65: (+$1,000/year): $1,036,964.14
It’s very important to recognize that this person has 30 years of compounding to achieve those balances.
If our above investor waited until they were 50 to start investing, the retirement balances would be shockingly lower. If a 50 year old started with $15,000 and retired at 65, his or her balance would be $38,906.14. Not a small sum, but hardly the $262,741.03 that the younger investors will enjoy. The earlier you start, the better.
“But I will just wait until I’m older and making more money. Then I’ll be able to save more!” Although this sounds like a good plan, the power of compounding shows that it will not be nearly as effective to save more later down the road. Even if our 50 year old got a raise and was able to add $5,000 per year on top of the initial $15,000, the total at 65 would still only be $118,593.26. This is about $80,000 less than the 30 year old who started with $15,000 and never added a cent!
A lesser known term is the Rule of 72. This is a simplification of compound interest which leads you to a rough idea of how long it will take for your money to double. Let’s use our above example to illustrate: You have $1,000 saved at 10% and want to know how long it will take to become $2,000. The easy back-of-the-envelope math is: 72 divided by the annual percentage rate, or 72/10=7.2 in our case, 7.2 years. This assumes a consistent annual interest rate. It may be an over-simplification but it will give you a general idea of where your money stands.
Let’s follow our example back to the beginning. Assuming a 10% annual rate of return, 72/10 gives us 7.2 years until our money doubles and becomes $2,000. So, every 7.2 years, our money should double. We can exercise the Rule of 72 again to find out how long it will be until our $2,000 doubles. At about 14.4 (7.2 x 2) years, we will have $4,000. Following so far? 21.6 (7.2 x 3) years go by and we have $8,000 and so on. Following this progression where our money doubles every 7.2 years, with an initial investment of $1,000 and a growth rate of 10%, at just over 43 years, we’ll have $64,000. So, if you’re in your early 20s and can afford to put away a few thousand dollars and forget about it for 40 years or so, you should be sitting pretty!
Back of the Envelope Finance 