Personal Finance

Compound Interest: Einstein Loved It—And You Should, Too. Here’s Why.

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compound-interest

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

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When I was in my early 20s, I read an article about compound interest that really stuck with me. The writer said that if you put away $2,000 a year from age 22 through 30, and then never add another dime, you would have more money at the retirement age of 65 than someone who put away $2,000 a year every year from age 30 through 65.

What?!?

Related: The 5 Steps Necessary to Master Your Personal Finances

Compound Interest: A Real Life Example

Math is not my friend. I am great at many things, but math doesn’t even come close to making the list. So the scenario above didn’t make any sense to me. Twenty-two through thirty is 8 years. Thirty through sixty-five is 35 years. So it’s $16,000 vs. $70,000, and the $16k wins? I didn’t believe it. So I went to the Dave Ramsey Investing Calculator and plugged in my numbers. Let’s check them out:

compound interest calculator

In this first image, you can see that I contributed a total of $16,000.32 or $2,000.04 a year for 8 years. Then I stopped contributing — but the money kept growing to a grand total of $707,041.40!!! Wow, that’s a lot of money. But surely if I put more in for a longer time, I will have more, right? More is more. Let’s take a look at that chart:

compound interest calculation

In this image, you can see that I contributed $70,001.40. That is more than 4 times the amount contributed in the first scenario. I contributed four times as long, and my total is $596,265.38. That comes out to $110,776.02 LESS than the first scenario. Contributing more to earn less sounds like the losing strategy to me. I guess Mies van der Rohe was right. (He’s that architect who said, “Less is more.”)

So let’s go back to that initial article, which compares 22-30 vs. 30-65. What happens if we combine those two and start contributing at age 22 and then never stop?

compound interest retirement

A whopping $1.3 million, simply by putting away $166.67 every month for retirement. Now imagine how much you would have if you increased your retirement savings whenever you got a raise? (If you put away $255.77 every month, your total is over $2 million.)

Check out this pie chart below, which shows how much of that total is interest! Turns out 93.4% of that $1.3 million is interest! It is actually really hard for me to wrap my head around how little of that total came out of my hypothetical pocket and how much came from investments, which in essence funded my retirement.

compound interest retire

Something many people don’t consider is that the best time to start investing is right out of college. You are just exiting a time in your life when you had no money. Once you get a job and the money starts coming in, most people start spending it to either make up for when they didn’t have anything, or to keep up with the Joneses.

But what if you continued to live like you had no money?

Live Like You Did in College

In college, you probably had a roommate (or three) to share expenses. Ramen noodles was a staple of your diet, and you rode your bike around campus because you had no car. What would happen to your bank balance if, instead of finding your own place once you got a job, you continued to live with roommates who helped share your expenses? Better yet, how far ahead would you be if you bought a house and rented the extra rooms out?

Related: 3 Negatively Cashflowing “Assets” That Devastate 20-Somethings’ Finances

Potentially, your roommates would pay your mortgage, freeing up your money to work for you even more by allowing you to pay off student debt, consumer debt or even allowing you to purchase another property to rent out. If you were lucky enough to have a car in college, it would do just as good a job getting you to work as it did getting you to class. Resisting lifestyle inflation is a powerful choice that may make you a multi-trillionaire* some day.

Compound interest is a ridiculously powerful tool in your retirement arsenal. But you have limited time to take advantage of it. The earlier you start, the more you will have. Even Albert Einstein believed in the power of compound interest. Have you started saving for retirement yet? What is stopping you?

*Not guaranteed to happen.

**Featured image by Underwood and Underwood, New York [Public domain, Public domain or Public domain], via Wikimedia Commons.

[Editor’s Note: We are republishing this article to help out readers newer to the BiggerPockets Blog.]

Are you using the power of compound interest to help prepare for retirement? Have you passed on this lesson to your kids?

Leave a comment, and let’s talk!

Mindy Jensen has been buying and selling homes for more than 20 years. She buys houses, moves in, makes them beautiful, sells them, and starts the process all over again. She is a licensed real est...
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    Michael Seeker Investor from Louisville and Memphis, TN
    Replied over 5 years ago
    Love the article and love the power of compounding interest! I completely agree with the idea of living below your means and putting that extra money to work. It doesn’t take long to recognize the benefits. That being said, I’d be curious if the 8 years vs. 35 years would come out differently with say a 7-8% return. While many investors are fortunate enough to hit a CAGR of 10%+, it’s not a foregone conclusion and I think the norm is certainly less than that. 10% compounded returns will take some work, whether it be owning a business, owning income producing real estate or studying the stock market enough to get an edge there’s more to just socking away a couple hundred bucks a month and expecting to be a millionaire down the road.
    Frankie Woods Investor from Albuquerque, NM
    Replied over 5 years ago
    10% has been the average rate of return for the s&p 500 index since the 1920s. It’s not guaranteed, but hardly out of reach for your typical investor who status the course.
    Mindy Jensen BiggerPockets Community Manager from Longmont, CO
    Replied over 5 years ago
    Thanks for reading, Frankie. Yes, one of the most difficult things to do is not sell when you see your investments losing money. Past performance is not indicative of future gains. But the stock market has always recovered. Individual stocks may fall to zero (Enron anyone?) but the overall market has an upward trend.
    Mindy Jensen BiggerPockets Community Manager from Longmont, CO
    Replied over 5 years ago
    Thanks for reading, Michael. I chose 10% to illustrate the concept. 10% isn’t guaranteed, and the results would certainly be different with a 7-8% return. I don’t think 10% is an unattainable goal, but you do make an excellent point – there is a touch more to investing than just socking away a couple hundred dollars a month and expecting to be a millionaire down the road. For fun, I went back to the calculator and plugged in 7% as the rate of return, investing the same amount for 8 years. In 43 years, it would be worth only $234,419.60. Far less than the 10% return…
    Shaun Reilly Landlord and Rehabber from Newton, Massachusetts
    Replied about 5 years ago
    BTW to show that the rate of return is by far the most important thing if you run the analysis only changing the interest rate starting late will give you more cash at the end when your annual return is less than about 8.7%. Now it is still a lot more efficient to start earlier but beating out long contributions overall depends on a LOT of compounding.
    Jessica L Renard
    Replied over 3 years ago
    Precisely, not taking wipe out conditions added to stock market investing; not to mention decided fork in returns for inside and not-as-inside responsiveness in stocks. Modern mutual funds getting to consistent 10% in the mix of all else has presented interesting updates in analysis. Shrivner for shrivner sakes, gets us shrivening and out of touch with joyful purpose. Compounding promises are not unchallenged, as nothing goes unchallenged, and significant efforts are never diminished by any leverage.
    Michael Seeker Investor from Louisville and Memphis, TN
    Replied over 5 years ago
    Love the article and love the power of compounding interest! I completely agree with the idea of living below your means and putting that extra money to work. It doesn’t take long to recognize the benefits. That being said, I’d be curious if the 8 years vs. 35 years would come out differently with say a 7-8% return. While many investors are fortunate enough to hit a CAGR of 10%+, it’s not a foregone conclusion and I think the norm is certainly less than that. 10% compounded returns will take some work, whether it be owning a business, owning income producing real estate or studying the stock market enough to get an edge there’s more to just socking away a couple hundred bucks a month and expecting to be a millionaire down the road.
    Matthieu Drula from London, England
    Replied over 5 years ago
    I’d love to see where you get an easy 10% interest rate, in the UK banks only make a 4.5 % max. So to get 10%, you’ll need to take more risk.
    Mindy Jensen BiggerPockets Community Manager from Longmont, CO
    Replied over 5 years ago
    Hi Matthieu. I chose 10% to illustrate the concept. I didn’t mean to imply that you would be earning 10% every year, although it is certainly doable.
    Jessica L Renard
    Replied over 3 years ago
    It’s a mixed bag for assessment, for sure.
    Jessica L Renard
    Replied over 3 years ago
    It’s a mixed bag for assessment, for sure. Reply Report comment
    Jessica L Renard
    Replied over 3 years ago
    It’s a mixed bag for assessment, for sure.
    John Thedford Hard Money Lender, Broker Associate, Investor from Naples, Florida
    Replied over 5 years ago
    To get 10% you have to take more risk. There are avenues that can generate well over 10% with very little risk IMO. And yes, compounding is the name of the game! Start building your retirement early and stick with it.
    Mindy Jensen BiggerPockets Community Manager from Longmont, CO
    Replied over 5 years ago
    Thanks for reading John.
    Andrew Chou Investor from Sunny Isles Beach, Florida
    Replied over 5 years ago
    My favorite book, and probably the best authority on the subject, is Stephen Kellison’s “The Theory of Interest”.
    Mindy Jensen BiggerPockets Community Manager from Longmont, CO
    Replied over 5 years ago
    I have not read this book yet, but I’m putting it on my list. Thanks for the recommendation, Andrew.
    Mike Kelley Investor from Gardendale, Alabama
    Replied over 5 years ago
    My favorite investing Rule: “Rule of 72” Love how money doubles with certain percents of interest gained. Powerful Leverage…
    Mindy Jensen BiggerPockets Community Manager from Longmont, CO
    Replied over 5 years ago
    I wish they would teach this in high school or even middle school. Thanks for reading, Mike.
    Rick Grubbs Rental Property Investor from Salisbury, NC
    Replied over 5 years ago
    Remember also that your 20’s can be a valuable and unique time for new life experiences you may not be able to do as easily later on when marriage and family generally take place. I did lots of volunteer work for my church in my 20’s and don’t regret that today. I started investing in RE at 27 and by focusing on cash flow properties that has kept bread on the table for our family of 14 ever since.
    Mindy Jensen BiggerPockets Community Manager from Longmont, CO
    Replied over 5 years ago
    This is a good point, Rick. I don’t think you should give up all your experiences in an attempt to save money. But many fresh-out-of-college kids buy brand new cars – or worse, lease them – and new clothes, shoes, etc. Yes, they probably need a work-appropriate wardrobe, but that new car will cost so much more in opportunity costs.
    Andrew Syrios Residential Real Estate Investor from Kansas City, MO
    Replied over 5 years ago
    Unfortunately, most people go about this reverse with things like credit card debt and just end up in lots and lots of debt. We desperately need some sort of financial education in school, although I don’t know how much it would help.
    Mindy Jensen BiggerPockets Community Manager from Longmont, CO
    Replied over 5 years ago
    Thanks, Andrew. It is a culture-wide problem that will probably never be addressed. Parents don’t know how to handle money, and they teach their children not to handle it properly as well. I would LOVE to see financial education in school. I remember being taught how to write a check, but nothing about making sure you have money in the account to cover it. And absolutely nothing about saving for a rainy day or preparing for unexpected events. Sigh.
    Shaun Reilly Landlord and Rehabber from Newton, Massachusetts
    Replied about 5 years ago
    This kind of stuff is great for illustrative purposes to show people that they should invest early and hopefully they get the additional point of needing to get consistent high rates of return. 10% year over year over year can be done (though it is more likely to even out from years of 20% and years of -3%, etc) but few people will ever attain that. The typical person that isn’t investment oriented but at least contributes to their company retirement plan will usually do far worse because they will buy lack luster investments, they will have high costs, when the markets are doing bad they will panic and sell to lock in losses and then will buy more when things are going up fast to limit their upside potential. Run the analysis using 4% and see a) which does better and b) see why people that only put small amounts of money towards their retirement are in for a sh*t show…
    Jessica L Renard
    Replied over 3 years ago
    The costs are nearly designed to suppress retirement expectations, too. Disappointing models in it today… more must advocate more than ever.
    Jessica L Renard
    Replied over 3 years ago
    The costs are nearly designed to suppress retirement expectations, too. Disappointing models in it today… more must advocate more than ever. Reply Report comment
    Curt Todd Investor from Happy Valley, OR
    Replied over 3 years ago
    And don’t forget investment gain is taxed. So you don’t actually get to keep all of that money which you passively earned. Oh far from it, but still better than nothing – or bad debt.
    Julie Rogers from North Lauderdale, Florida
    Replied over 3 years ago
    Nice article. Great food for thought!
    Shaun Milligan from Kinston, North Carolina
    Replied about 3 years ago
    Loved your article. I have hears this before but I tend to forget how powerful compound interest really is. Thanks for sharing.