Uncommon Cents: Compound interest: eighth wonder of the world

Business | Tech

Albert Einstein was in awe of the concept of compound interest. We are all affected by it, whether we understand it or not. Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it . . . he who doesn’t . . . pays it.”

Interest is the sum charged on an original amount of money (the “principal” — a loan or deposit) you either borrow or invest. There are two kinds of interest. Simple interest is charged only on the principal or the initial amount. Compound interest is calculated on both the principal and the interest that accrues on that principal. Compound interest refers to your money’s ability to grow over time, depending on how much money is invested, what the interest rate is and how patient you are. It requires patience because it is boring and seems to do very little in the early stages.

This concept is crucial to know. It underscores how important it is to simply get started at the practice and patience of saving as soon as possible.

Here’s an example. Someone (let’s call her Liz, age 20) starts saving while at university: $50 per month for five years. She earns five per cent compounded interest per year.Assuming all the factors remain stable, Liz would have over $3 400 in her account after five years. Doesn’t seem like much, does it? She graduates, gets $45 000 per year at her job and puts $100 per month in the same account for 15 years, again at five per cent compound interest. In 15 years, her money would be somewhere around $34 000. Liz is now 40 years old. She gets a raise and makes $50 000 per year now. She decides to put in another $400 per month at the same rate until she is 65 years old. When she retires, her investment will be worth around $356 000.

Here’s a different scenario. Two good friends — let’s call them James and Zack — learn the same lessons about financial planning and compounding at university. James decides he is going to start investing right out of university. He decides to put $200 per month away at five per cent, no matter what. From ages 25–35 he does well, but then he becomes ill and stops saving, but leaves the money in the investment. The principal he contributed, without compounding, would be $24 000. With compounding, the total would be about $31 000 at the end of these 10 years.

His best friend, Zack, decides he is going to live it up for a while, and does so until James can’t work anymore. This crisis hits Zack powerfully. He decides life may be short, but he might have a long retirement. He starts putting away money at the time when his friend James becomes ill. Zack starts at age 35 and puts away $200 per month until age 65 at a compound interest rate of five per cent.

Who (Zack or James) will have more money when they both turn 65? James will have more than $130 000, and Zack will have more than $160 000. But the real difference is that James will have only put in only $24 000 of his own money, while Zack will have put in $72 000. James’s initial investment was less than Zack’s, but James’s money had longer to work: it is not timing that makes the difference, but how long your money is in and how patient you are. To repeat: the amount of time you consistently stay in the market, not trying to time big wins, is what will get you further in the long run.

As Einstein’s quote suggests, if you owe money and are paying interest at a compound rate, you will pay a good deal of interest on what you buy. If you are saving at a compound interest rate, you stand to reap great rewards later on. The lesson here is: get started. Put some cash away now in a disciplined, consistent manner, even if it’s only $25 or $50 per month. While you are in school, put it in a Tax-Free Savings Account (TFSA) — in my next column, I’ll explain why a TFSA is a better choice for students than an Registered Retirement Savings Plan (RRSP). Like the scenarios above, continue to do so over time. You will reap the rewards of financial security long into your future. Sounds boring and mysterious, perhaps, but compounding makes all the difference between living well and living not so well later on in life.

Please note: all calculations in this column were made using an HP 10b11= calculator, and numbers are rounded.