Investing 101 – Part 2: Compound Interest

Hello and welcome to the second installment of the Investing 101 Series.  In the first post of this series we went into an introduction of investing, which you can find here:

• Investing 101 – Part 1: Introduction

How many topics in school did you cover that are actually real world applicable?  Who really needs to know when Columbus sailed the ocean blue or how to calculate long division?  Unfortunately our school system is a bit misconstrued and we are taught how to memorize pretty useless facts (in my opinion) that likely do not have much real world application.  I digress… One math subject that everyone should become very familiar with is compounding.

What is Compound Interest?

Compound interest is interest that earns interest (tongue tied yet?).  It requires two things: the re-investment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment. Let’s look at a few examples:

Example 1: How Does Compound Interest Work?

Suppose you saved $100 a year ago and it grew at 10% meaning it earned $10 in interest last year (100 x 0.10=10). This year, assuming you leave the principal ($100) and earned interest ($10) in your account, you’ll be earning interest on $110. That might not seem like much, but understanding that simple fact can have a major impact on your future financial success.  The key take away is that it can turn just a few dollars today into big money over the course of a lifetime.

Now you may be thinking, “OK sure, but where am I going to see 10% returns?”.  It’s true that banks aren’t paying much on savings accounts (maybe 2-3% for a high interest savings account). However, many index funds tracking the stock market average a higher return, have very low minimums, and low expenses ratios (keep reading the investment series for more info on index funds). Over the past 100 years, the S&P 500 has grown on average roughly 10%.  This does not include inflation, so I like to use 7% on the high end for my estimates to account for 3% inflation.

Example 2:  Slow and Steady

Say you saved $5 per month and put it into an investment account that earned on average 5%.  If you were to save $5 per month continually for 10 years you’d have put $600 into savings (5 x 12 x 10=600). But thanks to that 5% annual compounding, the account would be worth $776. And, even if you didn’t add a single dime after that point, it would be worth more than $1,500 in another 15 years.  The point is, it adds up faster than you may think.

This example shows how something small, like cutting out a morning latte once a month, can help your investments grow.  But we here at the Modern Fimily are not about depriving yourself of the small things you do that truly brings you joy.  You can really see the power of compound interest if you focus on cutting your largest expenses and invest hundreds, if not thousands, a month.

Example 3: One and Done

Let’s say you’ve been saving for some time and now have $10,000 in your bank account but not sure what to do with it.  If you invest $10,000 today and it grew at 6%, you will have $10,600 in one year ($10,000 x 1.06=$10,600). Now let’s say that rather than withdraw the $600 gained from interest, you keep it in there for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236.00 ($10,600 x 1.06) by the end of the second year.

Because you reinvested that $600, it works together with the original investment, earning you $636, which is $36 more than the previous year. This little bit extra may seem like peanuts now, but let’s not forget that you didn’t have to lift a finger to earn that $36. More importantly, this $36 also has the capacity to earn interest. Assuming 6% growth again, after the next year, your investment will be worth $11,910.16 ($11,236 x 1.06). This time you earned $674.16, which is $74.16 more interest than the first year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on. This will continue as long as you keep reinvesting and earning interest. If you’ve ever heard of the Rule of 72 and the notion that your investment will double in “xx” years by dividing 72 by the rate of return, it’s thanks to compound interest.  

Let’s say you left that original $10,000 in the market and assume 6% growth, on average, over a 40-year timeframe.  The Rule of 72 would say that every 12 years (72/6=12), your portfolio will double.  So year 1 = $10,00, year 12 = $20,000, year 24 = $40,000, year 36 = $80,000, etc. After 40 years, that original investment of $10,000 would now be worth $109,574.  If it happened to grow at 10% on average, it would be valued at $537,006 after 40 years.

Now let’s say you held off and kept that $10,000 sitting under a mattress for 20 years until finally deciding to put it into the market.  If that $10,000 only had 20 years to grow, it would be valued at $33,102 assuming 6% average annual growth or $73,280 assuming 10% average annual growth. That’s a difference of $76,472 for the 6% growth or $463,726 for the 10% growth. 

THIS is why the saying “time in the market is better than timing the market”.  Sure, the 6% growth will vary year over year, but it’s a realistic return to be averaging.  

Example 4: Monthly Savings Really Do Add Up

Let’s say every month you were able to save and invest $250.  If you never increased the monthly contributions and continued to contribute $250/month for 40 years and it grew at 7% on average, after 40 years your account would be worth $660,281.  If it happened to grow at 10%, you’d be sitting at $1,594,445.

Now let’s say you were able to boost that $250/month saving up to $500/month (because if you’re reading this, you’re likely a life hacking badass and can figure out a creative way to either reduce your spending by another $250/month or increase your income by the same). Assuming 7% growth, after 40 years it would be worth $1,320,562.  Assuming 10% growth, after 40 years it would be valued at $3,188,890.  If you plan to work for 40 years this is the simplest example to becoming a millionaire once you retire.

In the first part above of $250/month of contributions, you’d be putting in $120,000 of your own money (250 x 12 x 40).  In the second part of $500/month of contributions, you’d be putting in double that of $240,000 of your own money (500 x 12 x 40).  That difference of $120,000 yielded $660,281 more in your account 40 years down the road assuming 7% growth or $1,594,445 if assuming 10% growth. That’s nuts!  

Example 5: Time is Your Best Friend

One of the biggest things to understand is that when dealing with compounding interest, your best friend is time. The sooner you can start investing, the better.  Even if it’s just $25/month to start.

Consider two friends, we’ll name them Zoey and Dane.  Both Zoey and Dane are the same age and when Zoey was 25 she invested $15,000 earning an average return of 7%. For simplicity, let’s assume the interest rate was compounded annually (aka growing at a steady rate year over year).  By the time Zoey reaches 50, she will have $85,881.27 ($15,000 x [1.07^25]) in her bank account without adding another penny into the account.

Zoey’s friend, Dane, did not start investing until 10 years later when he reached age 35. At that time, he invested $15,000 at the same interest rate of 7% compounded annually (aka same set up as Zoey but just 10 years later). By the time Dane reaches age 50, he will have $42,734.20 ($15,000 x [1.07^15]) in his bank account.

What happened? They both are 50 years old, but Zoey has $43,147.07 ($85,881.27 – $42,734.20) more in her savings account than Dane, even though he invested the same amount of money! The power of time allowed Zoey to earn a total of $70,881.27 in interest and Dane earned only $27,734.20 in interest from his initial investment. Don’t get me wrong, $27,734 is a GREAT accomplishment but $70,881 seems so much sweeter.  

Example 6: The Double Whammy – Compound Interest + The FIRE Mentality

Here’s where the beauty of FIRE kicks in. While saving $250-500/month is nothing to laugh at, most people within the FIRE community are all about life optimization and figuring out creative ways to slash your expenses or boost your income to increase your savings rate so you can invest even more. 

Let’s say there are two people, Johnny and Jenny, making the same take home pay of $4,500 per month from their day jobs (you can also view Johnny and Jenny as two different families too who combined are making $4,500). Johnny tries to keep up with the Joneses but is not completely irresponsible and spends $4,250/month and invests $250/month (yay for not going into debt!).  Using the 4% “Rule” with Johnny’s monthly spending of $4,250, Johnny would need $1,267,500 to retire ($4,250 x 12 x 25=$1,267,500).  In order to continue living at this current standard of living in retirement, it takes Johnny 49 years to retire assuming 7% average annual growth of his investments.

Jenny, on the other hand, has embraced the FIRE mentality.  Not only has she mastered the big stuff to keep her expenses at $2,000/month but she has also implemented a low stress side hustle that brings in $500/month in addition to her day job.  So she is able to save and invest $3,000/month ($4,500 income + $500 hustle – $2,000 expenses).  That’s a 60% savings rate, nice job Jenny!  Using the 4% Rule with Jenny’s monthly spending of $2,000, Jenny would need $600,000 to retire ($2,000 x 12 x 25=$600,000).  In order to continue living at this current standard of living in retirement, it takes Jenny 11 years to retire assuming 7% average annual growth of his investments.

That’s a difference of 38 years of freedom for Jenny!

Now if instead Jenny was cautious and kept her $3,000/month in savings under her mattress or in a checking or savings account earning 0.05% (or lower) interest, rather than it taking Jenny 11 years to retire, it would instead take her almost 17 years to reach that $600,000 figure ($600,000/($3,000*12)).  By investing instead, she was able to shave off 6 years (or 35%) of her working career to reach her early retirement figure.

Not only does this illustrate the power of compound interest, it also shows the power of FIRE.  Because Jenny was a “weirdo” and deviated from the herd mentality of needing to upgrade her life to keep up with the Joneses, she was able to reclaim 38 years of her life where she no longer has a boss telling her what to do, or TPS reports to complete, or pointless meetings to attend.  People outside of the FIRE community can mock our lifestyle all they want, but THIS is the purpose behind it all.  To RECLAIM our lives back to be able to spend our time however we’d like.

Who Is This Jenny?

Jenny is not “normal” in her spending compared to 99% of her peers.  She understand the importance of reducing her top three expenses.  She house hacks and lives with roommates or has a rental property she is getting rental income from.  She likely has a short commute to work and takes public transit (gasp!).  She has drastically reduced her transportation costs as her reliable car was bought used and paid up front with cash. She doesn’t fall victim to eating out all the time and instead cooks most of her meals at home.  When she does eat out, she orders one of the cheaper meals on the menu because she understands how marked up items at a restaurant are priced.  Then when she goes home she googles a recipe for one of the menu items that sounded unique to try at home (and she then uses more brain power to acquire another skill to her already growing skill set). She doesn’t understand why people feel the need to keep up with the latest trends or own the latest technology gadget.  In fact, she takes pride that her phone is 5 years old and found a mobile plan that only costs $13/month (thank you Public Mobile). (Check out Ting if you’re in the US.)  She hasn’t bought new clothes in over a year and understands how much waste and pollution is created throughout the process of making many materialistic items for sale at the store.  When she does need new clothes, she looks for second hand items online at Craigslist (US) or Kijiji (Canada), or on Facebook Marketplace, or on apps such as Offer Up, Let Go, or Varage Sale. If she can’t find the item she’s looking for, she will head to a discount store like Marshalls, TJ Maxx, or Winners.  To socialize, she prefers to host pot lucks at her house or pick up a bottle of $7 wine to bring over to a friend’s house rather than going out for a fancy meal or to get drinks at a bar / club.  She enjoys nature and spends most of her free time outside.  She reads books while others are glued to the screens on their TV, phones, or tablets.  She listens to others rather than feeling like she needs to be the center of attention.

Most people reading about Jenny would be quick to assume she is living a deprived life.  But it’s the exact opposite.  She has learned to be at peace with fewer wants and needs and is a happier person because of it.  In fact, Jenny is living her best life.  She doesn’t have the stress and worry of living paycheck to paycheck.  She knows that she is living well below her means and her investments are continuing to grow and work for her.  And of course, after 11 years she can call quits on her job. 

We are the real life Jenny.  Literally this is us, I tried to explain what our life is actually like. And we are not the only ones out there living life like this while also maintaining JOY.  So many people can read this and say “oh come on, no one lives like this?!” but it’s so not true.  Break out of your comfort zone, challenge yourself, increase your savings rate, invest, and let compound interest do it’s magic.

Is There a Downside to Compound Interest?

The examples above show how useful of a tool compound interest can be.  And yes, compound interest is wonderful if you’re routinely saving money, but it can be absolutely cruel if you’re borrowing money.  Credit cards and other open-ended accounts use compound interest AGAINST you. Just as the examples above show how much extra money you can EARN thanks to compound interest, the exact opposite is true if you OWE interest to the banks.  That’s why “minimum payments” are likely to keep you in debt forever.  Suppose your interest rate is 14 percent (which is quite low for most credit cards) and you add just $5 per month to your payment. In 10 years, you’ll avoid $1,315 in payments.  We would never suggest investing if you also have debt with a 10+% interest rate.  Contribute to your 401k or RRSP for the company match but besides that, PAY OFF THAT DEBT! 

While some people view credit cards as evil, we love them.  Note however, we would never advocate running into credit card debt.  We use credit cards for travel rewards and have all of our accounts set up on auto pay to pay the balance in FULL each month.

Compound interest requires you to sacrifice today to reap a benefit tomorrow. It’s true that you’ll need to do something to save a few dollars today. But, it’s certain that the future reward will be greater than the sacrifice.  Saving a few dollars a week might not seem like much, but if done consistently it could make a big difference in your financial future.

Hopefully today’s lesson on compound interest helped tweak your view to understand the beauty of delayed gratification (whole other blog post on that in the future) and how important it is to invest as much as you can as early as you can to start letting compound interest work for YOU.  

Hope you enjoyed today’s post.  Honestly, understanding the beauty behind compound interest is SO important.

Any questions for us regarding compound interest?  Thank for reading along and stay tuned for the next installment of the Investing 101 series where we dig into the different types of account you can choose to invest in (US edition and then Canadian edition to follow after that).  

Want to check out the rest of the Investing 101 Series?

• Investing 101 – Part 1: Introduction

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We believe in stacking up life hacks to keep your enjoyment levels to the max without depleting your bank account.  Here are some ways to further educate yourself and save thousands of dollars over your lifetime by making some simple adjustments:

• How much are you paying for your phone plan?  Canadians, learn more about Public Mobile, and see how we are paying $3/mo for our cell phone plan.
• How much are you paying for internet?  Canadians, learn more about the various Independent Service Providers out there to see who services your area so you can lower your monthly bills.
• How much are you paying for home insurance?  We were able to reduce our rates by 25% by switching over to Square One Insurance.  If you live in BC, AB, SK, MB, and ON, check out Square One for your home insurance, landlord insurance, and/or tenant insurance.  Use this link to receive an extra $15 off your quote.  (Note that you must use this link to start the process to get the $15 off even if you prefer to pay over the phone.)
• How much are you paying for your monthly utility bills?  See how you can likely save on this monthly expense.

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