The magic of Compound Interest

We have all been told that it's never too early to start saving, why is that?

3 min read


Albert Einstein famously said, "Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.

In a nutshell

Compound interest is the result of receiving interest on your previous year's interest and capital.

Why does this matter?

Your pension will compound interest over the time it remains invested. The longer this happens, the bigger the effects of the compounding.

So what difference does it make?

Let's look at an example. We've assumed Geoff and James invest into the same pension fund returning 5% per year on the money they invest.

  • Geoff begins investing £300 per month into his pension age 25.  At age 65 his pension fund is worth £459,713

  • James begins his investment of £300 per month into his pension age 35.  At age 65 his pension fund is worth £250,717

Result: Starting to invest at age 25, compared to starting at 35, generated a whopping £208,996 difference to the final amount.

Business Insider UK* gave another good example (referenced from JP Morgan Asset Management 2014 Guide to Retirement) which is cited below. Note the currency could be Pounds or Dollars, it would make no difference to how compounding works:

  • Susan, who invests $5,000 per year only from ages 25 to 35 (10 years).
  • Bill, who also invests $5,000 per year, but from ages 35 to 65 (30 years).
  • And Chris, who also invests $5,000 per year, but from ages 25 to 65 (40 years).

It may seem obvious to most that Chris will have the highest amount in retirement, with $1,142,811. However the chart really does astonish us with just how much higher, as a result of compounding.

You can see that Susan, who only saved for 10 years compared to the 30 years that Bill saved, actually ended up with $602,070 at age 65. The fact Bill paid three times as much in but only received $540,741 at retirement, really does highlight the true power of compounding over time.

So, remember it is time that does the damage when it comes to pensions and the best time to invest, is as early as possible.

 

 

Sources:

Author

Sam Ro

Article title:

Every 25-Year-Old In America Should See This Chart

Website title:

Business Insider

URL:

http://uk.businessinsider.com/compound-interest-retirement-funds-2014-3