When you invest your money in the stock market, you will come across the term “compound interest” quite frequently.
This post is somewhat different from what I’ve done traditionally, but I felt like talking about compound interest was important. I won’t go into details directly on this, instead I want to focus on the numbers and visuals.
To help you fully understand compound interest and how it works to your advantage, I’ve created tables and charts in Google Sheets.
Now, I’m not a math wizard, data scientist, or spreadsheet, but felt this post needed it.
What is Compound Iinterest?
As I mentioned in the introduction, there are many articles on compound interest and how it works. So I don’t intend to spend a lot of time here explaining it.
However, a simple definition and context, I think, would be great.
Compound interest is simply the interest on the principal amount plus any interest already accrued.
And this is what the math formula looks like (I really don’t like math):
Say what? The definition is not exactly clear and why are there letters in this math equation !?
Kidding aside, that’s why breaking it down into simple numbers is easier. So here is the calculation with small numbers.
You invest $ 100 in an account that earns 1% interest each year. After the first year, you now have $ 101 ($ 100 *. 01 = $ 1, $ 1 + $ 100 = $ 101).
Now, if you didn’t contribute anything else in year two, then you would add your 1% interest on your $ 101. So after the second year you now have $ 102.01.
A common theme with new investors or those just trying to save for retirement is:
How will I get to six or more digits to be able to retire?
The answer is compound interest.
Examples of compound interest visualized
The definition and the mathematical equation can be a little intimidating at first, but I think the Basic Number Breakdown example clears it up.
But I still wanted to break this down further and show you how compound interest and your money become best friends.
For all of the scenarios below, this assumes the following:
- Average stock returns range from 7-10%, I choose to be more conservative at 7%.
- These do not take into account inflation over the years or the ups and downs of stock investing.
- It also does not take into account the costs of your investments or withdrawals.
These examples of compound interest are purely to get a rough estimate of certain numbers of compound interest being viewed.
I also found this formula and set it up via an old Reddit thread, then tweaked it to suit my style and what I wanted to show off.
Invest exactly $ 100 each year
If each year you only invested $ 100 and got an average return of 7%, in 20 years you would have $ 4,387. At 40 you would have finished $ 21,000.
Invest exactly $ 1,000 each year
If each year you invested $ 1,000 and got an average return of 7%, in 20 years you would have $ 43,865. At 40 you would have finished $ 213,000!
Invest exactly $ 10,000 each year
If every year you invested $ 10,000 and got an average return of 7%, in 20 years you would have $ 438,652. At 40 you would have finished $ 2,100,000!
To note: If you increased your contribution each year by 1%, in 20 years you would have $ 472,493 (a difference of $ 33,841). At age 40, you would have $ 2,404,931 (a difference of $ 304,931)!
Maximize your IRA
The current maximum contribution is $ 6,000, with this number generally increasing to account for inflation. These maximum contributions increase from time to time, as they were previously $ 5,500.
However, to keep it simple, we’ll just assume that you add $ 6,000 each year. If every year you invested $ 6,000 and got a 7% return, in 20 years you would have $ 263,191. At 40 you would have finished $ 1,280,000!
Maximize your 401k business
If you’re lucky enough to have a 401k business and can maximize it every year, you’ll be sitting pretty well. These data do not take into account inflation, company correspondence, etc.
Assuming you contribute $ 19,000 (latest contribution number as of this publication) and have an average return of 7%, in 20 years you would have $ 833,438. At 40, you would be over $ 4,000,000!
As you can see from the basic data and charts, the more money you save, the stronger your compound interest is for you.
Even if you are only investing the maximum in an IRA, take a look at what you can have in more than 20 years to retire. Another reason why investing whenever you can is important.
Again, the above data doesn’t count for inflation, withdrawal fees, and investment fees, but it should give you some thought and see the big picture (hopefully).
Now, of course, not everyone can afford to set aside up to $ 10,000 a year, or you can have a few years off to save money, or maybe you are maxing out a 401k.
Either way, doing something is better than nothing.
You can start small at $ 100 or $ 1,000 a year and gradually increase your contribution by X% each year and the compound interest can really take off.
This post was already published on Invested Wallet and is republished here with permission of the author.
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