Tuesday, February 23, 2016

The Power of Compound Interest & Why You Should Start Investing Early

Many people don't realize the benefit of investing early in life. Especially the young ones, who tend to have fun while they are still young. It's understandable why do such boring things while there are so many other fun activities in life besides investing. I myself sometimes find that saving and investing can be really boring (I am a human being and I want to have fun too). However, once you realize the power of compounding, you might get another picture why there are many benefit to start investing early in life. You see saving and investing is not a "get rich quick kind of thing", and if there is someone who claim to be able to get you rich quickly by investing, I hope you do your research diligently since there is probably high risk involved. Saving and Investing to create wealth is a long time procedure, but the sooner you start to put your money to work for you the more time your investment would grow better. 

So What Is Compound Interest?
Compound interest is an interest added to the principal of deposit or investment so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding. An example of compounding is when you invest $1000 and it generates a 5% interest, you will earn $50 in interest during the first year. However in the second year, not only will you earn interest on the principal, you will also begin to earn interest on the interest plus the principal in the account. So in the second year, the 5% interest will be credited in full $1050 you have in the account which will make your total account value $1,102.50. I know it doesn't sound like a lot in the beginning however if you kept the same $1,000 investment for a really long period like 20 to 30 years, you will see the compounding miracle.



Benefit Of Starting Early (TIME)
Benefit of starting early is that you have time working to your advantage, so the earlier you start the longer you are able to let compound interest working in your favor. Let's say you are lucky enough to be able to start investing at the age of 18 and you invested $1000 that generate dividends of 5% annually. Just by leaving the money alone and not touching it, it would generate handsome amount of $9,906 by the age of 65. The following year, it would generate you an interest of $495.30. That's a huge increase from original $50 interest you received in the first year. You are not even adding additional money to the account, imagine if you actually do! I have created a graph in the bottom to illustrate the power of of compound interest.


$1,000 Compounded Annually at 5% Interest Rate From Age 18 to 65 (47 years)

As you can see from the graph, as interest accumulate in the later year, the account value increases faster every year. What I'm trying to explain is, that if you start saving and investing in early age, you have the upper advantage of accumulating wealth.

Comparison Between Who Start Early and Later
In this example, I want to show you the difference between two people who start investing in early age and who start later. These are two completely different people and are both the age of 22. They both have just graduated from their university and started to have a job that provide them income. Bunny is a smart person. He understands the concept of compound interest and wants to start investing as soon as possible. He spends less than what he earned which enable him to save the rest. While Erica has completely different mind set. She wants to really enjoy her income out of her new job. She doesn't really care about the future because she believes that she wants to enjoy life while still young. She spends everything that she makes and doesn't even save a penny. 

Bunny is really savvy when it comes to saving. He was able to put $5,000 per year into an investment fund. Let's assume that this investment fund will generate about 8% annual return (pretty conservative measurement considering the fact that S&P 500 generate more annually). He does this every year and by the age of 32 he decides to stop. In those 10 years, from age 22 to 32, he contributed a total of $50,000 ($5000 x 10 years).

After 10 years at the age of 32, Erica begins to realize that she needs to have some money for her future retirement. She too decides to start contributing to her investment fund. Trying to match it up with Bunny, she also contributes $5,000 a year that generate 8% annual return. Feeling for being late, Erica decides that she would continue to contribute $5,000 per year until the age of 65. I display below the two savers' investment at the age of 31.


As you can see, Bunny already has approximately $78,227.44 in the account by the age of 31, and Erica didn't even put a single penny yet. The time Bunny decides to stop contributing in was the time Erica decides to start. But who will have a higher ending value at the age of 65? Let's take a look at the chart below.


At the age of 65, even though Bunny has stopped investing after the age of 31, he will still have an awesome amount of $1,070,944.07 in his account while Erica will only have $856,584.02. That's a difference of $214,360.05!

You also have to account the fact that since Erica invested at the age of 32 to 65 (33 years) while Bunny invested at the age of 22 to 32 (10 years). Erica contributed $165,000 into her account compared to Bunny who only contributed $50,000. That's a major difference of $115,000 more Erica contributed and yet she still lost to Bunny by $214,360.05. Pretty suck for Erica!

I just hope after reading this article you readers have a different view of why you should start investing early. The sooner you get started, the more opportunity you have for compound interest to work in your favor. So don't procrastinate anymore and start investing now!

22 comments:

  1. Sucha good way to explain abt comp inteterest! I need to start investing as soon as i hv the money .

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    1. Thanks for reading my article. I hope this article will inspire you to start saving & investing.

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    2. Anonymous missed the point. Start investing now! Any amount can start your lifetime habit.

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  2. Literate and easy to comprehend. Maybe the next article could be on variation of interest rates in different nations and how real interest rate plays a part of compound interest as well? :)

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    1. Hey Unknown, Thanks for reading my article.

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  4. DGB,

    I'm one of the many milennials and I can't tell you how many times I've tried to open up conversations with the friends about the importance of saving/investing NOW rather than simply living paycheck to paycheck. It's great to read articles that further support that it's a great strategy for riches over time and therefore independence from an employer that you probably don't care to work your whole life for in a shorter time. Liked the read, will add you to my followed blogs list.

    -Dividend Monster

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    1. Hey Dividend Monster, Thanks for reading my articles. I'm a new blogger and will be writing more in my spare time. I will add your blog in my blogroll. I hope you will succeed in the pursuit of financial freedom.

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  5. It's too late for me to experience the true power of Compounding. My kids however, will be vary happy that I forced them to start ROTH IRAs when they started working as teenagers.

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    1. Yes I think it will be a great idea to be able to teach this knowledge to our kids. It's this financial knowledge that will help your kids build the foundation to be financial free.

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  6. Very well written article on compound interest Hansen! I am very lucky to have learnt about compound interest a couple of years ago when I was in my mid twenties! This gives me plenty of time to let my money grow and compound.

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    1. Hey Money Grower, Thanks for visiting my blog and taking your time to read my article. Yes you are lucky to start in your twenties. I'm also very fortunate to be able to learn this simple but valuable knowledge from my brother at the age of eighteen. Hopefully I can use this knowledge to compound my investment and be financially free in my thirties.

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  7. Yes yes..compound interests are not magical but so so essential.. Point driven home.. :)

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    1. Thanks for reading my article Jonny Pean. Yes I totally agree with you, it's essential!

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  8. Great illustration about the power of compounding. Thankfully I found out about compounding at the relatively early age of 23. I believe that the time horizon that I have will be my biggest asset and I can't wait to see how much the money I am investing now will turn into in 20 - 30 years

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    1. Hey Money Grower UK, Thanks for taking your time to visit my blog and reading my article. Yes you start at an early age, you will meet your financial freedom sometime soon in the future.

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  9. Hi Bun,

    Starting early is very important. I am teaching my kids to invest now with their extra money. Another point is to never tap that money. Leave it alone and let it grow.
    Cheers,
    DFG

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    1. Hey Dividend Family Guy, I want to say thank you for visiting my blog and taking your time to read my article. Yes that's my plan with this portfolio. I am saving and compounding it for my future.

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  10. Compounding is one of the reason I got started in dividend investing and one of the reasons why I'm kicking myself for not having started when I was younger. To all the young folks out there, especially in your 20s: there is no time like the present!

    Great article Hansen.

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    1. Thanks for visiting my blog Glen. Yes it's better to start early than to start later!

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  11. This power leads to creating apps like this one

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  12. This comment has been removed by the author.

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