Wednesday, September 21, 2005

Why Compound Interest Loves Time

One of the things that I know I have on my side starting to get my finances in order at an early age is "time." When it comes to compound interest, time is your best friend. I will have close to 18 years of compound interest for my college education fund and over 60 years of compound interest for my retirement fund. One of my favorite examples of how powerful compound interest can be is the story of the American Indians and the $16 in beads and trinkets they received for an island called Manhattan.

In the early 1600s, the American Indians sold an island, now called Manhattan in New York, for various beads and trinkets worth about $16. Since Manhattan real estate is now some of the most expensive in the world, it would seem at first glance that the American Indians made a terrible deal. Had the American Indians, however, sold their beads and trinkets, invested their $16 and received 8% compounded annual interest, not only would they have enough money to buy back all of Manhattan, they would still have several hundred million dollars left over. That is the power of compound interest over time.

I did a few calculations:

For my college education, if I take the $2000 in principal I have now and can add $50 a month to it then I will have over $35,000 for college (assuming a 9% return). If I can save $100 a month for education, I'll have over $63,000 for college education.

If I wait 5 years to begin the compounding my results would only be $21,000 and $36,000

The savings are even more promising for my retirement. With no starting savings at the moment, if I can save only $50 a month for my retirement, I can have over $1.2 million in 60 years. Bump that up to $100 a month and I'll have over $2.5 million in the bank.

If I wait 10 years to begin the compounding my results would only be $533,000 and $1 million.

Time and compound interest go hand in hand and that is the advantage of starting my (and for anyone) savings early. Even those small amounts in the early years will pay off tremendously in later years.


Caitlin said...

what is most startling to me about this college math is that IMO, if a family is able to sock away $100/mo for 18 years that *should* buy a 4 year education. But these days, many private institutions already cost about $40k/yr so will $63k even buy one year's worth in 18 years time? I shudder to think maybe not.

Great point about manhattan :)

savingadvice said...

Yes, it is true about college costs. They are a bit deceiving in that the vast majority of students don't pay the full price since most get some type of financial assitance (kind of like paying full retail price on a car - most people negotiate for a better deal and pay less than the full retail price). I hope that this money in combination with grants / scholoraships I can get will let me leave college debt free...