Or, “Good Things Come to Those Who Don’t Wait”

Whether you’re already on the path towards a joyfully retirement or you want a little more proof that you need to start saving now, welcome! I’ve heard some troubling arguments about why starting young is unnecessary, why it doesn’t make sense to save a little each month for something that’s not happening for 40+ years, et cetera. Terrible. I’m here to share the facts behind why saving for retirement and investing that money, today, even though you’re a millennial spring chicken, is essential. Then I’ll maybe rail against various semi-compelling anti-savings arguments if I don’t get a handle on myself before the article ends.*

For now, let’s cover compound interest. Say you loan a friend a dollar, and he pays you back in a month with 10% interest. Ten percent of $1 is 10 cents, which is the interest you’ve earned. Compound interest says that if you earn interest every year and don’t withdraw what you earn (not that you would, because you’re smart and it’s all for retirement, duh), your interest earnings will compound and you’ll make interest money off of interest money – a very good thing.

Compound interest is basically a magic wand – crafted from your time in the stock market and your investments (and one phoenix feather, if you’re a Harry Potter fan) – that any young Retirist can wave over a small savings pile today to turn it into a bullion years later, with no extra effort but patience. If you’re still reluctant to invest now, realize that compound interest means that the earlier you invest your money, the less money you need to put in overall.

But don’t take my word for it. Here’s a story, some numbers, and some pictures to show how compound interest works:

At age 25, Athena has $1,000 to put towards her retirement. She invests that in the stock markets, where, for the sake of simple math, her $1,000 earns 10% interest that year. By the next year, Athena is 26 years old and now has $1,100 in her account. (10% of $1,000 is $100, which was added to the initial $1,000.) By the next year, Athena is 27 and has $1,210 because the 10% she earns in interest is compounding over time – 10% of $1,100 is $110, which adds to her $1,100 to create $1,210. Put another way, the value of “10% of her investment” grows each year because her investment grows as last year’s interest is added to her original amount. (The original amount is also known as her “principal.”)

Let’s adjust this story in light of assumptions you can generally, safely make about the investing world. Instead of 10% gains, we’ll say Athena’s investments have more likely earned 7% annually, a rate commonly used to estimate stock market gains over time. Drop that further to 5% in order to accommodate inflation, which is estimated as a loss of 2% of money’s value each year over time. (Note that these are long-term assumptions, meaning they’re only fair to make if you’re not withdrawing anything for something like 10+ years. Stocks can be up 20% in a year and down 30% in another, and inflation waffles annually, too, but they equal out to roughly 7% and -2% over time.)

So we look at the Athena example with $1,000 growing at a more realistic rate of 5%. Forty years later, at age 65, Athena has seen her initial investment of $1,000 grow to $7,040, and she didn’t even put in extra money! Seven times growth, people.

Compound Interest Retirement 1

Seven thousand does not a nest egg make, though, so what if Athena put in $1,000 each year instead of just that one-time $1K investment? By age 65, Athena will be sitting pretty on $127,840 – a pretty big bang for her buck considering she only saved $41,000, or $1,000 annually for 40 years starting at year 0.

Compound Interest Retirement 2

To more closely examine the power of compound interest for young investors, consider the value of Athena’s first $1,000 versus the value of her last $1,000. By the time she retires, that first $1,000 is more than seven times as valuable as it was before. (Remember from the first chart that $1,000 over 40 years blossoms into $7,040.) On the other hand, Athena’s last $1,000 contributed is basically worth just that, $1,000, because interest has not had time to accrue and compound. Make more money with less effort by exposing your money to compound interest early.

Compound interest happens through investing, so to be clear, don’t go and put all your money in a savings account: Invest instead. In today’s interest rate environment, savings accounts are not paying you enough interest to beat inflation, let alone make bank. The markets are a risk you simply need to take because if you don’t, and you stuff your money under a pillow or in your savings account instead, you’ll definitely lose out to that -2% inflation rate. To show what happens to $1,000 in a savings account even in a best case scenario, I’ll use 1%, which is among the top 10 best rates from this cool NerdWallet tool to find high yield savings accounts. It’s way better than the crap I’m getting at Chase (where I bank for other reasons) and generally better than many other options. However, is it bad for your money? Incredibly.

Compound Interest Retirement 3

The red line shows that $1,000 sitting in a 1% (“high yield”) savings account for 40 years is losing value because it’s not outpacing inflation, pretty much as if it were under your pillow. The chart is capped at $30,000 to zoom in on this disastrous effect: $1,000 has depreciated to a mere $669.

Zooming out on the same chart, that $669 is invisible. Instead, check out the damage done if you put $1,000 in a savings account annually instead of putting that same thing in an investment account. Remember Athena invested $41,000 and wound up with more than $127,000? This chart shows that, if you relied on a savings account, you would be contributing $41,000 in total… and ending up with a paltry $33,772.

Compound Interest Retirement 4

“All right, all right,” you might be saying. “I see what you mean. I must invest for retirement, and I must do it as soon as possible.” But how early do you really need to start investing for retirement to make use of compound interest? What’s the difference between a few years?

In this final chart, check out Athena’s $1,000 annual investment versus that of Dumford, who invested $2,000 annually, but didn’t start until he was 35.

Compound Interest Retirement 5

Yes, Dumford has come out slightly ahead of Athena’s $127,840 with his final nest egg of $141,522 at age 65. However, step back and consider the big picture: Dumford put in $2,000 for 31 years, meaning he contributed $62,000 while Athena only shelled out $41,000 by age 65. That means Dumford put in $21,000 more than Athena… but only made $13,682 more than she did.

So the choice is yours: double your contributions for 30 years or benefit wildly from 10 extra years of compound interest. And just imagine the possibilities if you were contributing a sensible amount!**

*Since I went a bit long with the facts, tune in another time for some theoretical concerns with putting off retirement savings.

**Meaning, $1,000 annually is probably not going to cut it. More on this in a future post, too.