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I’m sure you’ve already heard about the power of compound interest and how important it is to not just invest in your retirement, but to do so as early as possible.
When I was in high school, the screen saver on the family computer was a banner that read “Save 10% of your income from the age of 18 and retire at 45!”
I have to give my dad credit for trying to encourage me and my sister in any way possible to save money as soon as we started to earn it.
But when you’re young, it’s hard to see that far ahead. And unless you really see the numbers in a real-world example, it’s hard to actually believe it.
Sometimes, all it takes for that final nudge to start saving more is to see a relatable example. Or two.
The thing is, the power of compound interest is unleashed only with time. The earlier you start saving, the better. Either the shorter the time you have spend saving money, or, the less money you have to save over time.
If you start late, you have to save a lot more money in order to make up for the lack of time.In this post I’ll go over two examples that clearly demonstrate this.
Two real-world examples on the power of compound interest
Example #1: Everyone saves the same amount but they start at different times.
Example #2: Everyone ends at the same amount but has to adjust the amount saved to make it there.
Example #1: The power of starting early
In this first example we look at what would happen if three different people saved the exact same amount of money, but started saving at different times in their life.
They all start saving $1,000/month, and continue this over the course of 10 years. Each of them wants to retire by the age of 55.
- Carly starts saving at the age of 20 and stops by age 30.
- Tom gets a later start, saving at the age of 30 and stopping at age 40.
- Sarah starts even later, waiting to save until the age of 40 and stopping at the age of 50.
Since they all save the same $1,000/month over 10 years, they contribute $120,000. However, by retirement at 55 years old, they have vastly different portfolio values.
Assumptions
- Annual interest rate of 7%, compounded monthly
- Portfolio value of $0 at the start of investing
Results
By the age of 55:
- Carly has acquired just under $1 million for retirement.
- Tom has just under $500,000 saved.
- Sarah unfortunately only has just under $250,000 for retirement.
Thanks to the power of compound interest, Carly started early and was therefore able to sit back and watch her savings continue to build and rapidly grow over time. Even when she wasn’t actively saving.
Note: All calculations obtained by using the compound interest calculator from The Calculator Site.
Take away
Assuming Carly can live frugally in retirement, she can actually leave her job at the age of 55. Using the 4% rule, she can withdraw $40,000 a year for living expenses. Tom, however, will only have half of this, $20,000, and Sarah half again as much as Tom. No matter how frugal Sarah is, it’s unlikely she can live off of $10,000 a year.
If we stretch this out to the age of 65, the numbers are even more shocking.
- Carly would have $2 million for retirement, or $80,000/year of retirement income. In just 10 years she was able to double her portfolio value. Again, without any contributions after the age of 30.
- Tom would have just under $1 million, or enough for a frugal retirement.
- Sarah still wouldn’t have enough saved, only $500,000.
Moral of the story: It pays to start saving as early as possible.
Example #2: How much do you need to save to reach your retirement goal?
Let’s now look at the scenario where you want to build a retirement savings of $1.5 million. How much do you need to save in order to reach this retirement goal?
Well, it depends on when you start saving.
Let’s again look at three different examples.
- Carly starts saving $500/month from the age of 20
- Tom starts saving $1000/month from the age of 30
- Sarah starts saving $2000/month from the age of 40
Assumptions
- Annual interest rate of 7%, compounded monthly
- Annual 5% increase in contributions
- Portfolio value of $0 at the start of investing
Note: Why a 5% increase in annual contributions? This may seem unobtainable but when you factor in inflation, cost-of-living raises, employer contributions, education and experience with saving, as well as fending off lifestyle increases over time, this is quite do-able.
Results
- Carly is able to retire at the age of 54. The total amount deposited over 34 years is $510,000. Her portfolio value upon retiring is $1.5 million. If she actually waits to retire at the age of 60, she will have just over $2.5 million saved.
- Tom is able to retire at the age of 57. The total amount deposited over 27 years is $650,000. His portfolio value upon retiring is just over $1.5 million. If Tom holds off for just 3 more years, he will have over $2.1 million in retirement savings.
- Sarah is able to retire at the age of 60. The total amount deposited over 20 years is $790,000. Her portfolio value upon retiring is $1.55 million.
Take away
With the power of compound interest, the earlier you start saving, the less you have to save over time. Start early and then let compounding interest do the majority of the work for you.
If you start late, the more you will have to save in order to make up for the lack of time and compound interest effects.
Related reading from Stepping Stones to FI
- This is What Your Retirement Savings Needs to be at Every Age
- How To Calculate Your Savings Rate – And Why You Need To
- Money Crunching Mondays: Can You Invest and Save with Just $50 a Month?
