Guest post from Brother FI – Brotherly Advice on Love and Money: today compound interest
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If you put $100 in a savings account that compounds 1% annually how much will you have after one year? Hopefully, you know the answer is $101. How about after 2 years? 102.01. Where does that 1 cent come from? Compound interest.
This is one of my favorite personal finance topics and compound interest is something no one has yet to figure out. Honestly, I’m not even going to try to explain the mathematical formula and define the variables that go into it. You can just go google compound interest formula if you want.
For this episode, I thought it’d be best to show you how much your different expenses can cost you with compound interest. So that $4 latte you get every morning we’re going to look at that. The $200 cable/internet bill, the $523 car payment, the $2000 mortgage and yes even your $10 entertainment subscription.
What is Compound Interest?
First, let’s try to define compound interest. Bankrate.com says “Compound interest is a method of calculating interest whereby interest earned over time is added to the principal. As with interest generally, compound interest is the key incentive for banks to issue loans and for depositors to keep money at banks. It is applied regularly to savings accounts or loans according to various compounding methods.”
It’s this phenomenon where money saved, invested or loaned earns on money and more is earned on top of what was earned previously plus the initial amount saved invested or loaned.
I say it’s a phenomenon, because everyone knows generally what it is, but no one knows how to capture the true nature of what it is. Albert Einstein is said to have called “the power of compound interest the most powerful force in the universe.”
What I want to do next is go over what compound interest looks like for everyday monthly expenses. That $10 monthly entertainment subscription, the $4 daily latte which translates to $120/month, $200 monthly cable/internet bill, $523 car payment and the $2,000 mortgage.
Of course, these are general figures and the calculations I am going to share with you are not an exact prediction of future earnings. But I think this will be fun and eye-opening as you will see what compound interest can do for monthly bills and payments that you may not have to have.
I’m going to be using the compound interest calculator from Investor.gov. This proved to be a great resource and I like that you have the option to look at a range of interest rates above and below whatever interest rate you choose. For this exercise we’re going to look at these 5 different savings amount compounding annually at 8% over 40 years. Where does 8% come from you may ask? It’s generally what the personal finance community agrees will be your long term annual growth of money invested in a mutual fund like an S&P index fund or a Total Stock Market Fund. Not guarantees, but a lot of confidence out there.
Compound Interest Examples
$10 Entertainment Subscription
We all have that one subscription we love to keep. Whether it’s Netflix, Hulu, Amazon Prime or whatever it may be we “need.” $10/month compounded annually at 8% over 40 years gives you about $31,000 and you only contributed $4,800. Go ahead and enjoy your endless binge watching programs on the 3 different subscriptions you have. Something tells me you’ll reconsider the multiple paying subs you have.
The second monthly expense is the daily $4 latte so many of you love to have. That’s about a $120/month expense. I’m not saying don’t get your latte, cappuccino or coffee with 2 espresso shots, but be wise. $120/month compounded annually at 8% over 40 years yields about $373,000. Of that you only contributed $57,600.
$200 Cable/Internet Bill
Someone can correct me on this, but I figured $200/month on a cable/internet bundle sounded about right. Either way you’re looking at missing out on approx. $620k. Yup, that $200/month compounded annually at 8% over 40 years! What’s even more amazing is that you contributed only $96,000 in that 40-year period. Can you live off of $600,000+ in retirement? Maybe, maybe not. That all depends on your expenses, cost-of-living, any debt you may have and a topic we definitely will cover on a future episode very soon.
$523 Car Payment
I know this is one example you were hoping I would skip. I wouldn’t be BrotherFI if I didn’t keep it real like a brother should right? So, ladies and gentlemen, that $523 car payment compounded annually at 8% over 40 years yields about $1.6 million. How much did you contribute? $251,000. Of course I know you don’t have the same car payment for 40 years, but some of us do get new cars and stay with car payments for 15, 20, 30 years. Just get a reliable, used car you can pay cash for.
$2,000 Mortgage or Maybe Rent?
This last example is more of a visual to motivate you to save as much as possible. Many of us will never be able to save thi
s much per month, but in the previous example with the car $500/month or even $400/month I think is very possible. But for the heck of it, let’s see what saving $2,000/month comes out to be. Compounded annually at 8% over 40 years gives you about $6.2 million. You contributed $960,000 of that 6.2 million.
Now that you see what compound interest can do you have to make a choice. If you’re not already saving and investing you’re missing out. Remember, as every financial institution makes sure to emphasize on their websites, “past performance is not an indication of future earnings.” We could hit another recession tomorrow or fall into some very tough economic times over many years to come. This is always a possibility, but what I’ve learned is that it doesn’t take much to save each month. And if you’re that pessimistic over the stock market you can always diversify with bonds, real estate, CDs, high yield savings rate accounts that are FDIC insured.
I’ll end with a quote that will hopefully make sense to you now. Another Albert Einstein quote, although there’s debate if he actually came up with it. Doesn’t matter, here it is: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” He who doesn’t understand compound interest pays it and he who does understand or somewhat does earns it.
Check out the table below I created for you that shows you the 40-year progression of various monthly expenses compounded at 8% over 40 years. Pretty cool table, right?