Anyone in the FIRE movement should be very familiar with the concept of compounding interest. In the long term investment world, compounding interest is your best friend. Given enough time, it does a lot of the heavy lifting for you. In basic terms, the idea is the more money you have the more money you can earn. Money makes money. By reinvesting the dividends you receive from investment, the next dividend would be larger and then larger again the next time. So on and so on.
Even though I felt I had a very strong understanding for the concept early on, I really felt that seeing it mapped out was far more powerful. This is what I would like to show you here. I have also included a link below to a useful online calculator which graphs this this very well.
Before I start, the following assumptions are being used for the this example;
- Starting balance of $5,000
- Modest growth of 5% p.a.
- Additional contributions after the first year - $12,000 p.a. (or $1,000 a month)
- Interest will be reinvested.
- Period – 30 Years.
Specifically on the following table I will focus on the following years.
- Year 1
- Year 10
- Year 20, &
- Year 30.
The following is a table which shows how your money would grow over the 30 year period given the above.
The first column shows what your savings would look like if it was not invested and therefore not earning any interest.
The third, fourth and fifth column shows you how your savings would grow with the money invested assuming you reinvest the interest made each year as well as your yearly injection of funds.
Lets take a look.
The first thing I would like to look at is the difference in all 4 years between the “Cash under the bed” vs the invested “Opening Balance”
In year 1 the difference is only small. $250 extra. That is 250 extra dollars for setting up a small investment folio. If we look at year 10, that difference grows to a little over $34,000.
If your money is sitting under the mattress collecting dust then you have missed a very large opportunity. If you had invested it and achieved an annual return of 5%, then after 10 years you would have an extra 34k at your disposal. This would be all for a relatively small amount of work up front. This only gets larger the longer you invest.
The second element to this which I would like to draw your attention to is difference between the closing balances at each year with the year before it.
In year 1 and even year 10 the closing balance growth is mostly entirely made up of the yearly injection of personal funds. Year one increased by $12,862.50 compared to year 0’s Closing balance, of which 12,000 was your own money. Year tens’ closing balance increased by $19,953.96 compared to that of year 9’s closing balance. That means in 10 year, for doing the same thing as year 1, you have earnt an additional $7,091.46 without changing a single thing. The money is working harder for you.
This keeps on getting stronger each year due to compounding interest.
Let’s look at year 20. In Year 20 the closing balance increased by $32,502.90 from that of the closing balance of year 19. Again without changing a single thing you have gone from earning an extra $862.50 in interest to now interest of over $20,000 without working extra time at the office or starting a second job. Not to mention that you are now sitting on a nesting egg of $430,560.83. Not bad considering the alternative of having the money under the bed would be only $245,000.00. (that’s an additional $185,560.83 over 20 years for minimal extra work.)
The longer you let compounding interest work, the more you get back. In year 30 the closing balance will have increased by $52,943.79 in comparison to that of year 29. Now if we take away the 12,000 injected that year, you are left with an increase in funds due to interest alone of $40,943.79. That means for investing the same 12,000 each year for 30 years you would have invested $365,000.00 excluding any interest, and that 365k would now be worth a whopping $859,819.68!!!
That means if you invest 12k a year into a portfolio giving a minimum and consistent retune of 5% P.A. you would have made an additional $494,819.68 for doing absolutely nothing. More than doubled your money!
For me this is an amazing calculation.
It shows you that patients and consistency works in your favour when you allow compounding interest to take hold.
The following link is to the moneysmart compound interest calculator which is very useful and shows clearly the power of compounding interest. (no affiliate connection, just a useful tool I have found and used many times) https://moneysmart.gov.au/budgeting/compound-interest-calculator
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