Albert Einstein is reputed to have said, “Compound interest is the eighth Wonder of the World. He who understands it earns it; he who doesn’t, pays for it.” What is compound interest? What does it have to do with saving? And why did one of the most renowned academics in history compare the idea to the eighth Wonder of the World?
When you save or invest, your money accumulates interest or appreciates. The next year, you earn interest on your initial investment and the interest from the first year, and this cycle repeats—like a snowball rolling down a hill, building upon itself.
To give compound interest a bit more context, look at this example of two ambitious women. Valerie and Ash were college roommates and have recently graduated with their bachelor’s degrees. At 22, they both have careers in the fields they studied and love their jobs. With the beginning of adulthood staring them down, Valerie decides to save $3,000 per year towards her 401(k). Ash feels that since she has graduated from college and started her career, she needs to treat herself by purchasing a boat. So, she takes out a loan that’ll be paid off when she is 30.
At age 30, Valerie decides to start thinking about having a family and stops making contributions to her 401(k) to plan for expanding her family. Ash pays off her boat loan and decides it’s time to start saving for retirement, so she starts allocating $3,000 annually to her 401(k). Valerie and Ash have similar investments in their retirement plans: both averaging a 10% annual return.
FAST FORWARD: Now, at age 65, both roommates are retiring. Valerie has contributed $24,000 of her own money to her 401(k), while Ash contributed $105,000. Herein lies the magic of compounding: Valerie’s 401(k) at retirement has reached a total of $964,128.85; Ash’s is $813,073.11. Ash contributed $81,000 more of her own paycheck to her retirement, but she still ended up with $151,055.74 less in her account!
Who doesn’t want to have more money without contributing as much? All you need to do is start saving earlier in life. The tale of these women is a real-world example of how important it is to start saving for retirement as soon as possible because it will cost less in the long run. Ash was contributing her own money for over 35 years; Valerie contributed for 8.
Compound interest can turn a little bit of money into a lot of dough without working 9 to 5, and you do not need to be an Einstein to utilize it. All it takes is a little bit of discipline and a lot of patience. When you’re young, you have an asset money can’t buy… time. Use it wisely!