If I were to ask you to guess the eighth wonder of the world, what do you think it would it be? A historic landmark, a famous mountain, or waterfall in the jungle somewhere? As nice as those options sound, compound interest takes the cake (in our mind at least).

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

The purpose of this blog post is to help illustrate the power of compound interest and how you can apply this principle to your own investing. Put simply below, you can see that in year two and year three you are earning a return of 6% based on $106.00 and $112.36 respectively. This is due to the fact that the interest earned in year one and two is now being compounded, and interest is being earned in year two and three on the $100.00 principle in addition to prior years' interest earnings.

Year 1: $100.00 * (1.06) = $106.00
Year 2: $106.00 * (1.06) = $112.36
Year 3: $112.36 * (1.06) = $119.10

Below are two examples to drive home the point.

Illustration 1

This first illustration examines three different individuals who contributed to their investment portfolio at different times in their lives. We calculated the value of the portfolio at retirement (age 65) for each individual. For demonstration purposes only, we used an estimated annual rate of return of 6%.

Ed – Started to contribute $5,500 per year at age 25 until age 35. This is a total of $55,000 over the ten-year period.

Mary – Unlike Ed, Mary waited until 40 to start contributing to her investment portfolio. She began contributing $5,500 at 40 and did so until age 60, representing $110,000 in total contributions over the years.

Chris – Like Ed, Chris began contributing to his portfolio at age 25 and did so all the way to age 65. Chris's total contributions are $220,000.

 

Upon retirement at age 65, it is clear that Chris has the largest nest egg with about $956,398 in his portfolio. Chris began contributing at the age of 25, invested a total of $220,000 and realized the benefits of compound interest over the long term.

Over the years, Mary had contributed $110,000 in principle to her portfolio. She began to do so at age 40 and stopped at age 60. Her nest egg at retirement amounted to approximately $304,215.

Finally Ed, who contributed the least in principle contributions ($55,000) has a nest egg of $467,834 at retirement. Ed's portfolio is about $163,618 higher than Mary's due to contributing to his retirement fund sooner at age 25, and leaving more time for the portfolio to grow. This is an example how the compound interest in Ed's portfolio allowed him to contribute less and end up with more than Mary.

Illustration 2

This second example will reveal the monthly portfolio contributions that are required at different ages to reach a portfolio value of $1,000,000 at retirement (age 65). For demonstration purposes only, we used an estimated annual rate of return of 6%.

 

As shown above, if $1,000,000 is required at age 65, the required monthly principle contributions will range from $362.85 if contributions commence at age 20, increasing all the way to $14,332.80 if contributions commence at age 60.

Having addressed the required monthly contributions to reach $1,000,000 at different ages, I will be the first to admit that this illustration takes a couple items out of the picture. One item specifically is “life”. Cars break down, homes need repairs, and employment income may fluctuate. These illustrations however help show the importance of putting money away early, and paint a picture of what retirement will look like if certain contributions are made and returns are achieved.

By investing sooner rather than later, and utilizing the eighth wonder of the world, you may just be able to earn enough to travel and see the seven wonders of the world in person!

These calculations and projections are for demonstration purposes only. They are based on a number of assumptions and consequently actual results may differ, possibly to a material degree.

Sources

Business Insider
Quotes On Finance