Saturday, December 25, 2010

The Beauty of Compound Interest (or, Invest Young!)

P = principal amount (the initial amount you borrow or deposit)
r  = annual rate of interest (as a decimal)
t  = number of years the amount is deposited or borrowed for.
A = amount of money accumulated after n years, including interest.
n  =  number of times the interest is compounded per year 
Compound Interest - Ain't She a Beaut?

There is a parable circulating in the financial blogs and pages about investing for retirement.  Suppose you take two young Engineers, Steve and Dave, who graduate from college at age 22 and get good jobs.

Steve puts 10,000 every year into his 401(k) plan until he is 35.  At that point he gets married, and with a baby coming, he cannot afford to invest in the 401(k) plan anymore.

Dave, on the other hand, wants a new car and to go out to bars all the time.  He contributes nothing to his 401(k) plan until he is 35.  He realizes with horror that his net worth is basically zero and he has nothing saved for retirement.  For the next 30 years, he puts $10,000 into his 401(k) every year.

Who ends up with more money?  Let's use our Compound Interest Calculator and find out.

Steve has about $204,842.81 in his account at age 35 if we assume an average rate of return of 5% (which we will do for all examples).  After another 30 years, this accrues enough compound interest to yield $885,318.82

Dave, on the other hand, putting $10,000 into his account every year for 30 years, ends up with 740,827.32

Funny how that works, eh?  Money put in early trumps MORE money put in later.  Steve contributed only $140,000 to his retirement account, while Dave put in $310,000 - more than twice as much!

Of course, we haven't mentioned their friend Joe, who consistently put $10,000 a year into his retirement account from age 22 to 65, walks away with a staggering 1,582,926.73  It isn't hard to become a millionaire in this country.  Pay off the mortgage on an fairly average sized home over 30 years and put aside a few thousand dollars - a lot of people can do it.

What do we gain from all of this?

Well, first of all, if you are young, start investing NOW.  Even a "little bit" put in your 401(k) can add up to a whole lot down the road.  A dollar invested now is worth $2 in 10 years, $5 in 20, and $10 in 30.  The more you can sacrifice when you are younger, the more you will have when you are older.  And let's face it - we all know that young people squander a ton of money on status items, entertainment, and partying.  If you can cut back - even a little bit - it will pay off handsomely in the long run!

Second of all, if you are "putting off" investing in your retirement plan because "more immediate needs" like cable TeeVee, a fancy smart phone, or a lease on a car seem more important, it may be time to re-think your priorities.  You are literally spending money today that you will need for tomorrow in retirement.  There is no "tomorrow" to start investing - you need to start now.  And oftentimes that means paying off debts and working toward getting debt-free as well.

Third, if you are over age 50 and haven't saved for retirement, well, you're screwed, is all I can say.  You will end up living on Social Security and what little you can save between now and then, plus possibly whatever you can inherit from your parents (unless, of course, you are one of those remaining few who have a cushy pension plan and health benefits).

Fourth, if you fall into that third category, all is not lost.  There are clean, safe and enjoyable retirement communities where you can live in a park model style home for not a lot of money.  It isn't grand living, but it isn't starving, either.  And if you can save more NOW, you still might end up with a small next egg before retirement.  $10,000 invested annually between age 50 and 65 could yield $247,364.20 by retirement, at 5% interest (which is a little more than what Steve had when he was 35!).