Use Saving and Compound Interest to Build Wealth. No, Really.
"Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it." - Albert Einstein
It feels like we beat this drum over and over, but the point is so important, it bears repeating. Investors who can contribute consistently to their savings accounts can use compound interest to build substantial wealth.
Compound interest is earning interest on interest, as well as on principal. Simple interest is interest on principal only. The difference between the two is why paying off a car loan is more manageable, and oftentimes easier, than paying off a credit card. For a credit card balance, if you pay just the monthly minimum, you will add years of interest to your original principal. If, for example, you owed $10,000 on a card with a 12% APR, and made minimum monthly payments, it would take 30 years to pay off your card. And you would add over $16,000 in interest over that time. That’s like using black magic on yourself.
But when you leverage compounding interest on your savings, the magic works for you, and the results can be remarkable. The trick is that to get to the good part of the compound interest story, you have to fight off your self-sabotaging instincts.
Let compound interest work for you
The exponential power of saving and compound interest on your investments can be difficult to conceptualize because it works in a non-linear construct. It isn’t a simple equation like 1 + 1 + 1, it’s X = [P(1+1)n] - P. Conceptualizing compound interest isn’t something you can do in your head, and is nowhere near as easy to grasp as a 7% annual return. So, it's not surprising that for many investors, the natural impulse is to focus on returns. But by forgetting about returns, and focusing on what you can control, savings, you can leverage a truly powerful financial tool.
Let’s use another example to illustrate. You receive an end of year bonus that nets out to $10,000. You ask your adviser to find a fairly conservative place for it, one that will yield an average annual return of 5%. The funds are invested and you let it sit. The chart below illustrates how this would play out over 50 years. Based on a 5% return that compounds once annually, after 3 years you’d have earned $1,576 in interest. If you left it alone for 10 years, you’d have earned $6,288 in interest, and after 40 years, you’d have earned $60,399 in interest. After a fairly slow start, the tail-end of this chart rises dramatically, nearly doubling in value from year 30 to year 40.
Now, of course, you can never guarantee returns, and past performance does not indicate future returns. But for reference, the S&P 500 has an inflation adjusted average annual return of 7% since 1957. Were there some down years? Definitely. In 2008, the S&P earned -38.5%. But for investors who did not react emotionally, and instead let their portfolios ride it out, they typically experienced growth of 300% or more since the lows of 2008.
The point is not that volatility can yield tremendous opportunities, although it oftentimes does. It’s that when it comes to your portfolio, time in the market is much more important than returns. Which is why we advise our clients to start saving as soon as they can, reinvest their returns, and let compounding interest do the heavy lifting.
Saving and Investing
For a professional planning your retirement, starting to save and invest early can have a huge impact. Let’s say you were an early adopter, and starting at age 25, you deposited $500 a month into your 401(k). You kept this up every month, without fail, for the next 40 years, investing everything in a total US stock market index fund with 10% average annual returns. If you made your contributions religiously and never touched your portfolio, at age 65, you’d have over $3.1m saved for retirement.
A simple hack to pay off your mortgage quicker
Mortgages are similar to credit card balances, in that the initial payments are almost all interest and very little principal. The difference is that credit card balances are (hopefully!) much smaller, which means you can pay them off each month and avoid paying any interest. Mortgages are too big to pay off all at once, so a portion of your monthly payment will go to interest. You may not realize just how much though. The total interest paid on a $250,000 30-year mortgage at 3.0% is just shy of $130,000!
A simple hack to reduce your interest payments and shorten the life of the loan is to make one extra mortgage payment per year. The beauty of the extra payment is that it goes directly to principal because you’ve already paid the interest for the year. In the example above, if you made one extra payment per year – think baker’s dozen! - you’d cut 4 years off your mortgage, and save around $17,000 in interest. That’s $17,000 you could leverage in your retirement portfolio.
Start saving early to reap the biggest rewards
We’re not wired for non-linear thinking, yet almost all of our finances follow non-linear paths. Leveraging compound interest to grow your savings requires discipline, but is critical to achieving your financial goals for the future. By making disciplined choices early on, and ignoring market swings over the course of your career, you position your accumulated savings at the tail end of the chart above, when compounding interest pays the biggest dividends.
To learn how you can maximize your savings and plan for a financially independent future, schedule a call or a meeting with one of our fiduciary advisers. And if you don’t think you can save $500 a month, ask for Adam!
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Wright Associates-“Wright”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Wright. Please remember that if you are a Wright client, it remains your responsibility to advise Wright, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Wright is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Wright’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or at kswrightassociates.com. Please Note: Wright does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Wright’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.