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!
Adam K. Wright, CFA, CFP®
Adam guides the vision and implementation of the firm's fiduciary service approach and directs all client engagement, service integration and investment management practices.
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