The Power of Compounding Interest
Discover the 8th Wonder of the World
There are many decent examples of the impact of compounding interest on the Web, but they seem to fail at providing an example that is easy to relate to. I have created a scenario that will help you truly understand what Einstein calls the "8th wonder of the world."
Two students, each 18 years of age, graduate from High School. For their graduation gifts, Matt's father offers to put $20,000 into a savings account and Chuck's father offers to put $20,000 into a mutual fund. In both cases the graduates can not touch their graduation gift until they are retired.
Matt's father goes a step further and says that he will automatically add $20,000 into the savings account every year until Matt is retired. After Matt and Chuck discuss their graduation gifts, Chuck feels cheated.
For simplicity, we will assume that inflation is equal to 3%, Matt's savings account earns exactly enough to cover inflation and Chuck's mutual fund account earns 10% on top of inflation.
10 Year Reunion: At their 10 year reunion, Matt and Chuck compare notes. Chuck's graduation gift turned into $51,875. Matt's gift is now worth $200,000. Chuck feels cheated.
20 Year Reunion: Once again, Matt and Chuck compare notes. Chuck's graduation gift grew to $134,550. Matt's account balance was $400,000. Chuck feels cheated.
3 0 Year Reunion: Although it seemed unnecessary, Matt and Chuck compared notes. Chuck's graduation gift turned into $348,988. Matt's gift is now worth $600,000. Chuck feels cheated.
Don't worry, there was not a 40 year reunion. However, when it was time for retirement at age 65 Chuck did give Matt a call and they ended up talking about their graduation gifts. After 47 years, Matt had accumulated $940,000, all out of his fathers pocket year after year. After a one-time investment of $20,000, Chuck's graduation gift grew to a whopping $1,763,950! It was now Matt and Matt's father who felt cheated.
The chart shown in the upper right-hand corner of this page shows the growth of the two investments over time (you can also view the full table here).
In what seemed an unfair comparison, compounding interest was powerful enough to overcome a much smaller investment. If we put the two investment on even ground by adding in $20,000 each year to Chuck's account, the resulting balance would have been $17,599,856.
The name of the game is to invest early and to invest often. To further gain an understanding of this concept, try doing your own experiments with this simple compounding calculator.
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