Ep.39 - Why Compound Interest is like a Snowball Rolling Down a Hill (3 Minute Read)
Special Thanks to Guest Contributor Teurai Nugent for this post.
I’m sure you have all heard or seen the phenomenon of the rich getting richer while the poor get poorer. One thing that wealthy people understand is how to utilize and leverage the financial system to take advantage of things like compound interest and taxes.
Simply put, compounding interest can be one of the biggest levers of financial success when put to work for you, and one of the biggest contributing factors to financial collapse when working against you.
WHAT IS COMPOUND INTEREST RATE?
If you invest a sum of money (either a lump sum amount or monthly payments over a period of time) and leave it alone and allow it to work for you then what happens is your money grows faster and faster as time elapses because you begin earning interest on interest.
A great analogy is if you picture rolling a snowball down a hill. It may start off as only a tiny snowball, but as it rolls downward it gains momentum and accumulates more and more snow. When it finally settles at the bottom of the hill it’s a snowball big enough to marvel at.
The longer the hill, the longer it has to accumulate snow, and the larger it’ll be by the time it reaches the bottom.
The same concept can be applied to investing. The earlier you invest, the longer your “hill” is, and longer you’ll have for your “snowball” to gain size.
HOW MUCH DO I POTENTIALLY MISS OUT BY WAITING?
Let’s say I started putting aside $208 per month from my paycheck when I was 23 years old. That works out to around $2,500 annually and if we were to use a 10% interest rate (the average annual rate of return of the S&P 500 since its inception in 1928 -Investopedia), compounded over time until I am age 65 (42 years later) I would have amassed $1,615,411. You would have earned 15x your total investment of $105,000. You can use any compound interest calculator to run calculations.
Here is the link to the compound interest calculator that I used for this example:
Let’s look at what would have happened if I waited five years before acting, so the scenario now is that I am 28 years old and I finally start to put aside $208 per month from my paycheck. Again, this works out to about $2,500 annually and if we again assume a 10% interest rate compounded over time until I am age 65 (37 years later) I would have amassed $992,618. Again, you can use any compound interest calculator to run these calculations.
So the opportunity cost here would have been $662,793 ($1,615,411 - $992,618) that I missed out on that I could have easily gained by simply starting 5 years earlier (only costing me $12,500 more).
WELL, CAN'T I JUST MAKE UP THE LOST TIME BY INVESTING MORE LATER ON? NOT THAT SIMPLE
Let’s modify the same example above by comparing the two individuals again, but this time “Person B” will start 7 years later than “Person A” but will be increasing their investment to $333 per month, which works out to approximately $4,000 per year. Again, let’s see how things turn out for them by the time they both reach age 65.
Scenario 1: Individual A invests $208 per month starting at age 23 until age 65. That’s 42 years of investing (assume a 10% average annual rate of return). That would yield $1,615,411 from a cumulative principal of $105,000 ($2,500 x 42 years).
Scenario 2: Individual B invests $333 per month starting at age 30 until age 65. That’s 35 years of investing (assume a 10% average annual rate of return). That would yield $1,304,917 from a cumulative principal of $140,000 ($4,000 x 35 years).
As you can see, Individual B ended up investing $35,000 ($140,000 - $105,000) more than Individual A but in the end, Individual A still ended up amassing $310,894 ($1,615,411 - $1,304,917) more than Individual B.
That’s a 345K difference in missed cash flow ($35,000 + $310,894 = $345,894).
HERE IS HOW TO GET STARTED
That being said, I will share with you 3 cost effective investing platforms that I personally use and also recommend that are pretty straightforward, easy to setup, and aimed at keeping as much of your gains as possible in your pocket either by eliminating/reducing associated administrative costs and/or providing tax advantages.
- This is a great tool for the individual investor (an online stock brokerage), only accessible through a mobile app, that allows you to purchase stocks and ETFs with no commission. That means that Robinhood is completely free to use to buy stocks and ETFs. There’s no minimum account balance you need to maintain, and you can buy as much or as little stock as you’d like.
- I personally like investing in ETFs as opposed to individual stocks because ETFs aim to minimize your risk while still providing enough exposure to make gains over time. You will pay a capital gains tax on your gains.
Cash Accumulation in an Indexed Universal Life Insurance Policy (IUL)
This type of life insurance is another financial tool that I definitely utilize. I pay a monthly premium that is divided into two parts. A smaller portion (around 16%) goes into the life insurance part of it. The bigger portion (around 84%) is invested by the insurance company into the stock market. I participate in the gains of the stock market up to 13% ROI but I don’t lose any money if the stock market drops below zero.
Aside from enjoying downside protection, the other big thing here is that in the future when I want to tap into that accumulated cash, I won’t pay taxes on it. This is called a tax advantaged vehicle.
Employer Sponsored Retirement Plan
- 401Ks (403(b)s or 457s) are different types of retirement accounts allowing you to save towards retirement in a way that postpones payment of taxes until later when you begin to make withdrawals on your money.
- Your employer may have what’s called a “matching program” as an incentive for you to contribute towards your retirement. This means that they will match the amount that you contribute to your retirement up to a certain percentage of your income or up to a certain dollar amount. For example: Let’s say you make 50K per year, and your employer matches up to 5%. If you contribute 5% of your 50K, that works out to $2,500, and your employer will match you by that same amount, so you end up doubling your money instantaneously. Consequently, you are now able to leverage a total of 5K each year towards your retirement.