The most important financial concept you need to understand to take control of your financial life - compound interest
In ‘Why You Should Start Saving Now Part 1’, I outline a few bigger picture reasons that you should start saving now. Saving gives you control of your future, and allows you to dream greatly and set a plan for achieving those dreams. Saving is also a way where we can create financial capital which we can then leverage to create the changes we want to see in the world. In this article, we are going to be looking at a more technical reason you should start saving now. And the reason is…
To understand compound interest, we are going to begin by going over interest. Interest is the money an individual or corporation earns by lending someone else money. It is the fee you pay or receive in various financial interactions. Most people are familiar with interest from their credit cards, school or car loans, and bank account. When you just look at interest by itself it's a rather uninteresting concept, outside of getting irritated at the discrepancies between what the bank will pay you to save money with them, and what they charge you to borrow money! Interest is a straightforward concept where money is paid out at regular intervals and at a set rate as payment for borrowed money.
As you begin saving, you will acquire money that you will begin lending to various financial institutions (more on this at a later date!) and you will begin to collect interest. We call this savings your ‘nest egg’, it is the money you put away for your future and leave no matter what. Compound interest is the concept that as time passes you will earn exponentially more interest on your nest egg as previously paid interest dramatically increases your capital. That is a lot to fully comprehend and might not make any sense right now but we are going to spend the next few minutes diving deeper into understanding compound interest. I want to start with an old parable that is one of the clearest ways I have come to understand compound interest.
Years ago, there was a mighty king who every year took half of the rice grown from his pupils as a form of taxation. For many years, there were plentiful rice harvest and no one went hungry. During this time, they royal storehouses became very full. After many years, the kingdom had a bad year for growing rice. There was nothing for the people to give the king, or to eat for themselves. Everyone was hungry except for the king. As time passed the famine worsened, and the people grew even more hungry. Despite the terrible conditions facing the kingdom, the king decided to throw a royal feast for himself and his court. He had tons of rice carted in for the occasion in a royal parade. A little girl was watching the parade when she noticed that there was a hole in one of the bags, allowing rice to slowly fall to the ground. She quickly came up with a plan, and then raced behind the cart to catch the rice in her skirt. When the parade arrived at the castle, a few guards noticed the little girl and started yelling ‘Thief! She is stealing the kings rice!’ The little girl quickly responded ‘No no! I saw that rice was falling onto the ground and was simply catching it to return to the king’. The guards told the king about her noble deed, and the king asked to speak to the little girl. He was so touched by her loyalty, he offered her anything she could think of as a reward! ‘Can I have a single grain of rice?’ the girl asked. ‘I am offering you anything you could want. You certainly deserve more than a single grain of rice. Please ask me anything.’ the kind responded. ‘As you wish’ the girl began ‘could I please have a single grain of rice today, and then each day for thirty days double the amount of rice you gave me the day before?’ The king was happy to oblige this simple request, but couldn’t help thinking to himself that the girl would have been smarter to just request to keep the rice she caught in her skirt. The little girl was given the grain of rice and sent on her way. The next day she was given two grains of rice, then four. After a week, she was given 64 grains of rice which was enough for a small handful. By the end of the next week, the kings men had to count out over 8 thousand grains of rice enough to fill a small bag. The king was begining to realize that doubling the rice added up very quickly. By the 21st day, the king’s men had to count out over a million grains of rice. And at the end of the fourth week, they little girl was owed 134 MILLION grains of rice which were the entire contents of two royal store houses. On the 30th and final day of the debt owed to the little girl, the king payed out the rest of what he had in storage, 536,870,912 grains of rice! In total, the little girl had received over a billion grains of rice in 30 days. The king was devastated, he paid his debt like any good king would, but he no longer had any food to eat. He would starve! When he asked the little girl what she was going to do with all of her rice, she replied she was going to feed the kingdom, and she left a basket of rice for the king.
I love this story because it shows clearly compound interest works. For the first week there's a gradual increase in what the little girl is paid for her good deed, and everyone around her is thinking that she is foolish for her request. But as time passes, the amount owed to her grows quicker and quicker. This is why you need to get started saving now! The sooner you start saving, the sooner your savings will begin to grow to amounts impossible to imagine.
Next I want to take a minute to look at some more practical applications of compound interest for a young person just starting out. Lets compare the financial journey of three friends.
First lets take Kayla. Kayla is a bartender and makes about $15 per hour with tips so she makes about $30,000 /year. At 25, she decides to start saving 5% of her income for retirement right away. She does this until she retires, saving $125 per month.
Next, we will introduce Julie. Julie works at a coffeeshop and like Kayla she makes $15/hour or about $30,000 per year. Unlike Kayla, Julie decides that she is able to save 10% of her income towards retirement. For the next 10 years, Julie diligently saves $250 per month. When she turns 35, she has children and moves into a house so she decides she isn’t able to save any more.
And finally we will look at Kevin. Kevin works in Sales and makes $60,000 per year. At 25, he has lot of things he is eager to buy and he’s not really worried about retirement. When he turns 40, he starts to hear his friends talking about saving for retirement and begins to think that he should start to put money away. He decides to save 10% of his income, or $500 per month.
Let's look at how each of them do from the time they are 25 to the time they are 65. We will use a 7% annual interest rate for these calculations.
I included the top chart, because if you’re like me, you’ll love watch how the various savings plan work out year to year. But really all that’s important in the bottom chart where we can see the total amount each individual saved, how much the contributed to that savings and how much compound interest contributed to that final number. The results are quite astounding.
By the time she is 65, Kayla has saved up $344,448.36! She never saves more then $125 per month, but she does this diligently and never takes money out of her savings. This allows her to build up her nest egg and for compound interest to do the rest! By the time she is ready to retire she has contributes $61,500 to her account, and compound interest has contributed $331,242!
Even more impressive are the results Julie has! If you remember, Julie is able to save 10% of her income for the first 10 years of her working life but then because of the chaos of life never contributes again. Just like Kayla, she never touches the nest egg even though she is no longer contributing to it. After ten years, Julie has contributed $30,000 to her retirement account. By the time she is ready to retire, that number has increased to $361,242.27!
Finally and equally surprisingly we can check in on Kevin. Kevin ends up with far less money than either Kayla or Julie, only $288,034.43. But what I really want you to look at is how much of his own money Kevin has to put into his account to get that amount, 126,000. Kevin contributed double what Kayla did, and quadruple what Julie did to end up with worse results!
I’ve been learning about compound interest for years, and playing with graphs like these for the whole time. Still when I start getting anxious and have spiraling negative thoughts about the future, I look at graphs around compound interest and breathe a sigh of relief knowing that my financial future is one thing I can control. Understanding the power of compound interest allows me to know that by consistently saving income now, even if it doesn’t amount to much working in a brewery, I am setting myself up for a secure future.
Hopefully, if you delay savings by saying you can start when you are older these graphs will speak to you. No matter how much money you are able to save in the future, there is nothing more powerful than compound interest and time. So get started now!
If you look at these numbers and think, this is totally unattainable. There is no way that I’ll be able to save that much money. Start with something attainable - maybe $5 per week or $20 per month. After 40 years of saving, you’d have a savings account worth $56,539 and you’d only have contributed $9,840 to it. This is a major financial accomplishment, and I truly believe that once you start saving it becomes addictive so likely you will end up saving more.
In the future, we will discuss what to do with the money once you’ve saved it, ideas for saving more money, and everything you need to know to get started on the road to financial control. Saving now is a way for us to take control of our futures, live out our dreams, and be impactful in the world. And when we start now, we harness the power of compound interest we allow our savings to grow exponentially so we can attain secure financial futures, and positive social impact quickly.
Click here to read about what to do with they money you've saved!