When Does Compound Interest Kick-in?

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The day we begin investing money into interest bearing accounts we begin to earn interest on that money.  But for most of us the interest amounts earned on our savings can be pretty minute for quite a few years.  Oftentimes piddly interest amounts earned can discourage investors and savers alike causing many to fore go saving altogether, opting instead to use their discretionary income on the here and now.

To help us avoid this huge mistake, let’s spend some time studying the meaning and payoff schedules of compound interest.

Kick-in = when we start seeing our yearly interest payments supersede our savings contributions themselves.

If we contribute to our savings regularly, when will compound interest finally “kick-in?”

Let’s take a look…

Compound interest explained

Compounding – The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.  Also known as “compound interest”.  source: Investopedia

Compound Interest – Interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan or debt. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount.  source: Investopedia

Example: We have an annual salary of $50,000/year and save 12% of our pay.  At the end of the year we have $6,000, which earns us a 7.5% return in our retirement account leaving us $6,450.  If we continue to invest this money we earn interest not only on our original $6,000 but also on the $450 gained in interest on the original principal.

Why we should care

It can work for us…

Through the rough numerical examples above we are able to see how compound interest can be a very powerful savings tool that stands to benefit us more the longer we employ it.  That is why you always hear people saying to invest as early in life as possible.  The sooner we get compound interest working in our favor, the sooner we can live employment optional (my term for working when you want.)

Or it can work against us…

Anyone who has a mortgage is all to familiar with what I am about to say.  Let’s say your purchase a home for $150,000 with $0 down and finance it for 30 years at 5%.  You will have monthly payments of $805.23, with the majority going toward interest all the way until year 16 when your principal payments will begin to be larger than your interest payments.  When it’s all said and done, you will pay $139,883.68 in interest and your $150,000 house will end up costing you $289,883.68.

When does it pay off?

If we continue to save regularly, when will the yearly interest on our savings begin to supersede our savings contributions themselves?

The answer to that question is always going to be relative to how much we are earning and how much we are saving, but should generally conform to the secret of two times pay.

The Secret of Two Times Pay is a concept I recently came across while reading Your Money Ratios.  Author Charles Ferrell says that, “our finances hit a tipping point at about two times pay.” Charles goes on to say, “After you have saved two times your pay, the earnings from your capital will generally add more to your total wealth than the amount you save each year.”

Let’s consider our example from above once more:

Let’s assume we have been saving for 10 years and have $100,000 saved in our retirement account, or twice our annual pay.  With our 7.5% return the earnings on our $100,000 will be $7,500 which now exceeds our annual savings amount of $6,000.  This year we increase our retirement savings by $13,500 and more than half of it came from earnings on our capital.

How long will it take?

That all depends on you!

Don’t forget about the ‘Rule of 72’

The ‘Rule of 72’ – is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.  source:  Investopedia

Example: a 10% investment will take 7.3 years to double ((1.10^7.3 = 2).

Set a goal to save twice your annual income so you can begin watching your money work harder for you than you do!  This is a goal that is attainable with just a few years of disciplined, consistent saving.  Let’s use this as further motivation to stay on track.

All I know is the sooner we get out of debt and get started investing, the sooner we will be able to watch our capital work for us instead of us working for our capital!



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1 Ken

Good example. I look forward to the day when interest works for me and not against me.

2 Matt Jabs

So do I Ken! So do I! 🙂

3 Joe Plemon

Matt,
Great explanation. I wasn’t familiar with the “secret of two times pay”, but I like it because it is attainable and thus a great goal. Besides, having your money work as hard as you do is an awesome concept.

Many people never consider how compound interest works against them when they incur long term debt. They simply consider the monthly payments. I am glad you pointed it out.

4 Matt Jabs

I think the majority of us fail to plan for retirement because we think it is too far off and because we get overwhelmed with thoughts of “saving a million dollars.”

Breaking things down into understandable and achievable chunks helps us to visualize the goal thus making it more realistic and easier to implement.

5 Daniel

Saving $6,000 a year for 10 years won’t get you to 100k. Also where do you find a 7.5% interest rate? You may get 7.5% return on investment in a stock or mutual fund but not 7.5% interest. Interest is paid from savings accounts, cd’s, bonds and I don’t know of any paying 7.5% unless you are buying junk bonds and risking some of your capital.

6 BG

Daniel: saving $6k a year for 10-years while earning 7.5% interest will total $91,248.71 in 10 years. It will take, technically, about 10 years and 7 months to hit $100k — so it’s close enough for illustrative purposes.

Good point on the 7.5% savings rates — they are non-existent. But, if you have a 7.5% loan, then paying $6k a year extra on it will net you the same savings.

7 Mark

While the idea in this article is sound it doesn’t hold true due to the poor return on investment these days. Perhaps 30 years ago this was possible but today your lucky if you get 1% return on your savings.

8 Matt Jabs

Your point is so general it isn’t helpful. Yes, some investments are currently paying poor returns but others are paying well… you just have to know where to invest in all markets.

9 Matt Jabs

I am referring to rate of return on retirement accounts, not interest rates on liquid savings accounts. I must have somehow failed to make that clear. I read back over the article but am unsure what part of the article can I update to better reflect my true intent. Some help?

10 BG

Matt — compound interest doesn’t really apply to retirement accounts (in this sense), unless you are talking about re-investing dividends or something similar that is throwing off income (like bonds).

Stock investments are IMHO too volatile to give an accurate yearly ROR — you’ll get a different number for the ROR for every period you choose. For example, we have a negative annual ROR for the S&P 500 over the past 10-years, and there is no guarantee you will even get a positive ROR _ever_.

I, like Daniel, read this as savings accounts, not investment/retirement accounts because that is where compounding makes sense (at least to me), because the rates are always positive, and most of the time are known up-front.

11 Matt Jabs

Okay, I’m picking up what you are putting down.

You raise a valid point – you won’t get 7.5% interest per se – but 7.5% compound growth isn’t terribly unlikely on your total portfolio IMO.

12 Kevin@OutOfYourRut

This is the fundamental difference between rich and poor, the rich are on the receiving side of compound interest, the poor are on the paying side. It’s almost like a stealth transfer of wealth, the way it works so slowly and almost imperceptibly, even though we understand the mechanics of it.

“The Secret of Two Times Pay”–how does that work in an environment of 2% interest rates? I’m guessing that was hatched when rates were a good bit higher than they are now.

13 Matt Jabs

Like any good retirement forecasting model, the basis for these equations are founded on the principles of long-term returns over time, not specific time specific fluctuations in rates. All values in the examples are of course hypothetical, but are based upon reachable rates of return for the diligent investor.

14 Craig

Agree, this is new to me. Everyone talks about compound interest but I am having a hard time figuring out exactly how that is affecting my Roth IRA and general investing account. they have only been open since the summer and I know this will be huge over time, just having trouble figuring out the math of it.

15 BG

I hadn’t heard of these either, though I have long known the math behind them. Ultra-low rates on savings does suck right now, but that is even more incentive to _pay_off_debt_! If your savings account is paying 2%, and your mortgage rate is 5%, then why not get the extra 3% by paying on the mortgage (keep an emergency fund and proper cash flow).

If a bank CD ever pays more than my mortgage interest rate, then I’ll stop paying on the mortgage and start buying CDs. Either way (saving or paying extra on debt) is utilizing compound interest in your favor. Making minimum payments only maximizes the amount of interest the bank is going to collect from you (and is when compound interest works against you).

The trick is to get the bank to pay you, instead of you paying the bank.

16 Matt Jabs

This is why I love BG… he’s always urging people to pay off debt! Gotta love it. 🙂

17 BG

Matt — heh thanks!

The trick with paying off debt early, is that you don’t get a statement in the mail every month showing you the savings. I’ve paid off (early) a credit card, student loan, a car, and am now working on the second mortgage. Had I not paid those debts off early, I would still have all of those bills today.

I’d need to get the old papers, but I estimate that I’m “saving” about $600 a month in interest payments, because those debts are now gone. I’m also ‘compounding’ those savings, by using them to pay down the next debt in the snowball — so ‘compound interest’ works the same for paying debt off early as it does for savings accounts. Actually it works better because debt rates are much higher than savings account rates — so it makes sense to get the best rate for your dollar and pay down the debt.

My current loss in interest to banks is $550 a month now, and every month the number gets lower and lower — eventually the banks will be paying me (about 4 years from now).

18 gn

Enjoy your blog. Having a nest egg that grows faster than you are adding to it via savings is a nice feeling.

Lost the in the discussion of the beauty of compounding in savings accounts is the ugiless that inflation rates “compound” also. The value of the money in the account at the end needs to be discounted by the average inflation rate, COMPOUNDED over the time you are looking at. Whenever I see one of the beautiful charts showing the growth of X at Y% per year for Z years, I wish they would discount it using real (not reported) inflation rates to show that, after taxes, it can be a struggle just to break even on a real basis. Dont forget that you pay taxes on nominal gains, not real gains.

19 Matt Jabs

Great point GN and I suppose I should have touched on this in the article.

In the entirely hypothetical numbers used in the examples, I am assuming a 3% inflation rate making your “real rate of return” somewhere around 4.5% after inflation.

20 LeanLifeCoach

Matt:
Using averages and statistics can always be picked apart. The important thing however is whether or not someone gets the concept from the examples provided. Great job on getting the concept across.

The impact of inflation, the differences between real and hypothetical etc… are all subjects for future posts!

Keep up the great work!

21 Mrs. Money

The other day I figured out how much interest I had been earning when ING was paying 5% and then I saw how much I’m currently earning. It was totally depressing! 🙁 Compounding interest is great when you’re making the money!

22 Matt Jabs

@LeanLifeCoach: you got it! Focusing on minutia often causes one to miss the point.

@Mrs. Money: patience my dear… markets go up & markets go down, but it is the average with which we need to concern ourselves. 🙂

Also, what is your rate of return of your retirement accounts?

23 Robert Espe

http://www.soundmindinvesting.com/visitor/2010/jan/level2.htm

Regarding inflation and savings: the article above points out that while savings interest rates are at an all time low, so for the moment is inflation, meaning that we actually are seeing real returns on savings for once.

However, seeing that inflation usually averages 3%, that means our currency loses half its value every 18 years. Bemoaning this fact doesn’t help anyone, in fact it is the strongest argument for stock investing. While returns may not always look great, growth is the only way to preserve savings against inevitable decline, and there has never been a 30 year period where the stock market returned less than 8%. That being said, investor error can cause you to get a lower rate of return which is why Matt correctly recommends index funds for people who don’t consider themselves investors.

24 Kate

I am not sure if this is the same thing, but last night I was discussing with my friend about buying furniture at Rooms To Go. They are always advertising this amazing no interest, no payment deals and I am in the market for something for my dining room. She mentioned to me that as long as I paid off the furniture before the alloted time, it was a great deal. However, if I had any balance left after the advertised period, not only would I be charged interest on the remaining balance but on the full price of the furniture. Of course, I would make monthly payments to ensure I didn’t pay any interest, but it made me think that I needed to be careful on the amount I spent.

25 Matt Jabs

That is not the same thing, but since you asked… and it is a very pertinent personal finance topic, I will answer it in a new article tomorrow morning!

Keep an eye out for it.

26 Jamie Anderson

Compound interest can be effective, but it does depend on so many variables, e.g. the rate of inflation, interest rates, the amount saved and over how long. Unfortunately the answer is never black and white. I teach compound interest to young adults and use this compound interest calculator as a base http://www.inspiredtosave.com . It’s useful as it has a selection of interest and inflation rates and calculates how much interest you earn on one million dollars, based on these variables. However, the downside of the site is that it focusses on long term compound interest – some of the kids find it hard to visualise so far in advance.

27 Emily

It takes longer than most people want. But patient pays off…

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