Wednesday, November 28, 2007

Power of Compound Interest

A quick financial lesson. While this post may not seem relevant to me telling my back story, almost everything I talk about will be based on this concept, so pay attention. If you want to be rich, one of the most important things you will ever learn is the power of compound interest. This concept is best learned through example.

Let's say you decide to invest in a Roth IRA, my favorite investment vehicle. You decide to start one today and invest the maximum $4,000 every year. You invest it wisely in an index fund that follows the total stock market which has historically returned 10% a year. In 40 years, your $4,000 a year, ($160,000 in principal payments) turns into $1,947,407.24, All of it tax free.

Now imagine if you were a good little saver and have saved the last 4 years. With a modest gain over the last few years you have $17,000 in your account. With the same investment strategy above you now have at the end of 40 years 2,716,814.59, All of it tax free. That is almost $800,000 difference for saving a little bit earlier. That $17,000 turned into $800,000!

Still not convinced? How about this? You do the above strategy from the ages of 25-35 and then stop. So for 10 years you invest $4,000 and then nothing after that. By the age of 65 you will have an account worth $1,223,633,58. Your $40K turned into $1.2 Million.

Or instead, you do nothing from the age of 25-35 and instead save from the age of 35-65 with the same strategy. Your final balance will be $723,773,70. Your $120K turned into $720K. Not bad until you consider that that's a half-million dollar difference from the previous example of $1.2 Million! And you put in 1/3 the amount in principal and saved 3x as long!

The lesson? Save early, save often. I can't stress this enough to my young friends. I know it is hard to save money now, but in the long run, it makes a BIG difference. This concept applies outside of finance as well. Doing the right things today, can pay big rewards tomorrow. You should always have an eye on the future and understand that small differences today, can have big repercussions in the future. This applies to you choosing what school to go to, what job to take, whether or not you should buy that new TV, pretty much everything you can think of. The younger you are, the more important this concept is. Understanding this at a very young age, helped me to get where I am today as I will explain shortly.


  1. [...] young people who are wondering just how I did it and what advice I may have. Remember my post about compound interest? The point of that post was to emphasize how doing a little bit now, can pay big rewards in the [...]

  2. I am definitely going to be teaching my children about investing at a young age!