The Value of Compounding with 8% interest

The foundation of making correct decisions with regard to money and personal finance begins with basic financial knowledge. In working with consumers for over 35 years, I’ve discovered that often times people’s knowledge of these subjects is limited.  It is our goal at SILVER TALKS MONEY is to present these issues with clarity, in an easy to understand fashion.

Albert Einstein called the law of compounding the most important mathematical calculation ever conceived.(quote)
The pure definition of compounding is “interest on interest,” and recognizing the importance of this concept will allow for you to arrive at an incredibly important conclusion: you can make up the money, but you cannot make up the time.  If there is one key phrase from this segment…you just read it!!

The Rule of 72

Please allow me to explain in greater detail, using a logical and simple math example commonly known as the “Rule of 72.” To summarize, the rule of 72 states that when you divide your yield on an investment into 72, the answer will equal in how many years it will take for money to double. For instance, if you invest $10,000 into an investment that achieves a return of 8% per year, your $10,000 will grow to $20,000 in nine years if you do not make any additional deposits. The answer is achieved by dividing the return (8%) into 72; the answer being nine (years.) Hypothetical example used for illustrative purposes only.  Does not take into consideration the consequence of fees and taxes.  Not indicative of any specific investment.  Actual results will vary.

Using this example as a baseline, let’s look at the following example using fictional characters Chris and Pat. Chris joined the workplace soon after graduating from college at age 22, and immediately began investing $5,000 per year.  Chris continued this systematic investment through age 30 and then stopped contributing, but allowed his investments to continue to grow. For the purpose of this example, we are using 8% as the growth factor.

Pat, on the other hand, didn’t do much investing during his/her 20’s, but had an “aha moment” and began investing in the same consistent manner at age 31. Pat invested the same $5,000 per year until age 65.  The following table illustrates both examples.

The Value of Compounding with 8% interest

This example assumes an 8% nominal return compounded monthly, which represents an 8.3% effective return.

The conclusions we can draw are as follows…

Pat’s total contributions are $175,000 and Chris’ are $45,000, yet Chris has more money at age 65. Why is that? It is because of the power of compounding using the Rule of 72. For those of you who think you can buy your house, educate your kids, and then worry about retirement, I would say that is incorrect decision making. As we wrote earlier, you can make up the money, but you cannot make up the time. The sum which Chris has in the account at age 30, using an 8% compounding figure will allow the money to “turn” over four times by age 65.

Here’s an even more powerful example using the same parameters. Let’s say Chris saves $5,000 per year beginning at age 30, and Pat saves $10,000 per year beginning at age 40. Lets take a look at the results at age 60…Again, the same conclusion, you can make up the money, but you cannot make up the time!! Incredibly powerful stuff!!

The Value of Compounding with 8% interest

(Using flat 8%)

Hypothetical examples used for illustrative purposes only.  Not indicative of any specific investment.  Examples do not take into consideration the consequence of fees or taxes.