A Brief History of Time: Compound Interest

People are living longer and longer. Back in the Victorian times, you will be lucky to make it past your 40s. 3 of my grandparents are still alive at 70s, 80s so given the average agesof my grands and ever growing medical and  technological advancements, I estimate myself living to my 90s barring any natural disasters or personal misfortune.

Now I hope I am not going to need to work for a living when my joints grow old and creeky and become deaf as a bat so I have got to plan for my financial escape!

What? Planning for the retirement fund 40-50 years in advance? Isn’t that too early?

I don’t think so and let me introduce you to the 8th Wonder of the World, Compound Interest. Taking 50 years as the average working lifespan of the average person, let’s see what compound interest can do for us.

CI graph
Compounding 100/200/300/400 monthly savings for 50 years with 5% Annual interest

Consider the following scenario,

Starting from Zero Savings,

  • Saver A saves £1200 at the end of Year 1, and at the same rate for the next 49 years
  • Saver B saves £2400 at the end of Year 1, and at the same rate for the next 49 years
  • Saver C saves £3600 at the end of Year 1, and at the same rate for the next 49 years
  • Saver D saves £4800 at the end of Year 1, and at the same rate for the next 49 years

Factoring in an annual interest rate of 5% and assuming all interest remains within the savings pot and not withdrawn, at the end of Year 50,

  • Saver A has £238,112 (From an input of £1200×50=£60,000)
  • Saver B has £476,224 (From an input of £2400×50=£120,000)
  • Saver C has £714,336 (From an input of £3600×50=£180,000)
  • Saver D has £952,448 (From an input of £4800×50=£240,000)

You can see with annual compound interest of 5%, over the course of 50 years, the sum just about quadruples (~3.96x the orginal sum saved). You can just about see that the compounding graph is an exponential equation and if time is unlimited, soon the line would be a vertical line soaring for space! 

Putting it into context, how difficult is it for us to save 100 or 400 per month over the course of our working lifespan? If you have a decent stable job, then it should only be a motivational issue to keep that consistency up for such a long period of time. For many, trying to make ends meet is a miracle by itself, so even 100/month might be difficult. But the point is this, saving any amount consistently over a period of time with compounding interests, you can make the graph exponential and for money to work for you!

5% interest? How realistic is that? The Bank of England base rate and US Federal Reserve rate is still at an all time low of 0.50%. Market savings account interest rate are roughly on average 1-2% with some accounts offering ‘special rates’ with balance limits up to 5-6%. It appears doom and gloom for savers globally. Quantitative Easing (QE) over post 2008 crash have screwed us over. Perhaps it is time to looks at other asset classes to diversify savings. Cash has historically offered the poorest return of all the asset class. Whatever the rate is, the compound effect still hold true (unless its negative rates) and it makes sense to make use of this knowledge.

Next consider this next graph where annual compound interest is 5%

  • Saver A saves 100/month for the whole of 50 years
  • Saver B saves 200/month for the 1st 10 years then 100/month for the next 40 years
  • Saver C saves 300/month for the 1st 10 years then 100/month for the next 40 years
CI 10 years boost
Compounding Savings with savings boosted in the 1st 10 Years

At the end of Year 50,

  • Saver A has 238,112 (3.96x of actual cash saved)
  • Saver B has 339,310 (4.71x of actual cash saved)
  • Saver C has 440,509.9 (5.24x of actual cash saved)

By increasing the ‘pain’ of saving more in the early years, and then easing off, the compounding on the increased savings from the early years really work its magic over the next 40 years to speed up the exponentiality of the curve! In fact, if you can squeeze in as much savings as you can into the early years of your working life, the latter part of saving life will be very much easier.The earlier you plant your seed to grow your FIREplant, the more fruits you have to enjoy later in life.

My Notes

  1. The Snowball Effect
    1. Notice that the first 10-20 years of savings might appear to be a linear graph, but after year 20, the graph becomes more noticeably exponential. Let me give you a horticultural analogy: Your plant a seed to grow a FIREplant. When the FIREplant matures and produces fruits and in turn seeds. You harvest the fruits and replant the seeds back into the soil and grow more FIREplants. The new FIREplants will produce even more fruits and even more seeds. You repeat the same, year after year and in no time, you will have fields and fields of FIREplants, more than you can ever need and it all started with that one seed! Time is your friend in this case.
  2. All You need is Time
    1. Look at the Forbes Rich list 7 out of 10 in the top 10 list are over the age of 70. I wonder how much of their wealth is due to compounding their gains over and over again over their decades. Interesting to note, the other 3 who are under 70 years old are masters of Microsoft, Facebook and Amazon. So the key to growing rich, live for a long long time.

Takeaway Messages

  1. Saving/Investing – Start Early to leverage the compound effect
    • The best time to plant a tree is 20 years ago. The second best time is now.

  2. Keep a Steady Contribution
  3. Reinvesting Interest Earned
  4. Stay Healthy and Live a Long Long life.

So Start Growing Your FIREplant Today! 😀

N.B. Try out Monevator’s excellent Compound Interest Calculator to see how fast the snowball grows!

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