In these days of low, near-zero interest rates, you don’t hear people talk about compound interest. That’s the investing truism where you not only earn money on the principal you’ve invested, but also on the interest you have earned up to that time. As interest is continuously added back to your account, the power of your account to grow increases significantly over time.
We enjoy speaking to high school students about financial matters, and here is a story that describes the power of compounding very well.
Two students, Emily and Evan, graduate from high school in the same class. They go to the same college and actually pay the same in tuition each year. Evan borrows the standard federal student loan amount, $27,000 over four years, while Emily does not borrow any money.
They each graduate with the same degree, and as luck would have it, end up living in the same city, working for the same large employer, earning identical salaries. So far so good.
Six months after graduation, Evan begins repaying his student loans on a 10 year schedule, making the required $271 monthly payment. Emily decides at the same time to open a Roth IRA and sends off a monthly deposit also of $271. Over the next 10 years, Emily makes deposits totaling $32,500.
Evan seems Emily’s savings and admires that she does that, so when his loans are repaid, he opens and IRA and sends the former payment amount to his new retirement account. He never misses the money, and even though he is $32,500 behind Emily, he expects he will do just fine over time.
Emily shares her investment allocation with Evan, and he mimics it. As time goes by, their paths diverge, and they lose touch with each other. But they continue to invest!
Fast forward to their 50th high school reunion! Evan seems Emily chatting with some friends and goes up to her to thank her for the positive influence she had on him with her savings habit. “I just checked my IRA statement,” Evan says, “I’ve averaged 8% return and I have almost $700,000saved! Thank you again!”
Emily smiles but thinks inside that something doesn’t quite sound right. She taps her iWatch and pulls up her brokerage statement to check her Roth IRA balance.
I like to ask the students that they expect Emily’s balance to be?
A-$27,000 more than Evan’s (that’s the amount of his loans).
B-$32,500 more than Evan’s (that’s the amount of his loan payments).
C-Something else – how much more and why?
Most students correctly choose C, but few can come close to the correct amount. Remember that the only difference in Evan and Emily was that Emily started 10 years earlier. Their investments were the same and they earned the same rate.
In the end, Emily had $800,000 more than Evan. The reason? The Power of Compounding! Her extra $32,500 grew into $800,000 due to the power of compounding. Amazing!
You don’t hear too much about compounding these days with interest rates so low. If our sample savers had only earned 3% average, the difference would have been more like $100,000. Clearly the rate you earn matters. There is certainly risk of loss in investing and there are no guarantees that you will make money, but as an example of the way the math works, this is a great way to encourage an early start to saving money.