An Example Of The Power Of Compounding Interest

by Hank Coleman

Scenario: Worker #1 maxes out his Roth IRA investing $5,000 per year for the first nine years of his working life after college from the age of 22 to 31 years-old. After turning 31 years-old, he never makes another contribution to his IRA. His coworker, Worker #2, waits until the ripe old age of 36 to begin investing after having established himself in the workforce, bought a nice house, and taken several great vacations. Worker #2 invests $5,000 from the age of 36 until the day he retires at 65 years-old. Both earned 8% annually on their investments. Which worker has the bigger account balance at age 65?

The Results Of Compounding Interest

The power of compounding interestWorker #1 will have accumulated approximately $67,400 by the time he reached the age of 31, but then his investments continued to grow at the rate of 8% per year. And, he would ultimately finish with a nest egg of a little over $997,000 in his bank account by the time he retired at age 65. He only invested $45,000 of his own money over those nine years of his working life. But, waiting those fourteen years after college devastated Worker #2 though. He never recovered from his slow start. Although he accumulated about $920,000 by the time he retired, the loss of over $80,000, thanks to the late start, still has to sting. A loss of $80,000 in a retirement nest egg could equate to approximately $3,200 in retirement income lost per year. That is the power of compounding interest. Worker #2 also had to contribute $175,000 of his hard earned money over those last thirty-five years of his career to be able to retire with such a large nest egg.

Starting Early Makes All The Difference

Worker # 1 only invested for nine years but his investments resulted in almost $1 million and over $80,000 more than his co-worker who started late. That is the power of compounding interest. For example, between year number one and year number two, that $5,000 investment earned $400 assuming that average rate of return of 8% annually. That $400 then went to work for Worker #1 for the rest of his life. He didn’t put that $400 in the account. But, that $400 added over $10,000 more of his closest dollar bill friends to Worker #1’s account. That $400 would have been a nice friend to have your first year after college. It proved to be the gift that really did keep on giving. That first $400 of interest earned kept earning interest on itself to the tune of $10,000 over the next four decades. This is the power of compounding interest. Time is your best friend. There is no substitute to starting to invest early. Delaying your investment can be devastating.

While I am sure that a lot of people will point out that earning 8% per year is not realistic. It is an average. On the average, the stock market has historically returned 8% per year. Some years, it is more such as this year, and some years it is less. But, this example shows that there is no substitute to investing as early as possible. Time is your most important ally and the best thing young investors have going for them. Delaying the start of your investing can be devastating by the time you reach retirement age.

(photo credit: Shutterstock)

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