Investing For Your Future
Monthly IFYF Investment Message
April 2005
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Compound interest was described as the "eighth wonder of the world" by mathematical genius Albert Einstein. With his specialized knowledge, Einstein, more than anyone, understood that the process of earning "interest on interest" (i.e., compounding) is one of the most awesome aspects of personal finance. With time, even small investments can grow to large five-, six-, and even seven-figure sums. The amount that you are investing is less important than the process of establishing a regular saving habit as early in life as possible. That way, your money starts working for you by earning interest, dividends, and/or capital gains on top of the original amount (principal) that is invested. As your account balance grows, you earn interest on increasingly larger sums.
The good news is that you don't need to be a math whiz like Einstein to understand, and benefit from, compound interest. All you need to know is that TIME + INTEREST +MONEY =MAGIC. In other words, the longer you invest, the higher your average investment return, and the more money you invest, the more money you will accumulate for future financial goals such as a new car, college savings and retirement.
Suppose you receive a $2,000 income tax refund and decide to invest half of it ($1,000) and use the other half to pay off 18% credit card debt. The following table, from the U.S. Department of Labor publication Savings Fitness: A Guide to Your Money and Your Financial Future, shows the value of a one-time $1,000 lump-sum investment compounded at various rates of return over time. Increase the investment to $10,000 (e.g., a very big tax refund, inheritance, settlement, or 401(k) plan payout), and multiply the amounts in the table by 10, and the results are even more impressive (e.g., $10,063 x 10 = $100,630 for 10 years of compound interest on a $10,000 investment at 8%).
$1,000 One-Time Investment, Compounded Annually
| Year of Savings | 6% | 8% | 10% | 12% |
|---|---|---|---|---|
| 10 | $1,791 | $2,159 | $2,594 | $3,106 |
| 20 | $3,207 | $4,661 | $6,728 | $9,646 |
| 30 | $5,743 | $10,063 | $17,449 | $29,960 |
Even more impressive is effect of compound interest on a $1,000 annual investment, as shown below. The rates of return are hypothetical examples and are not meant to represent any particular investment product. Note the widening gap between account balances, at any interest rate, from 10 to 30 years of savings and, at any years of savings, from 6% to 12% interest.
$1,000 Annual Investment, Compounded Annually
| Year of Savings | 6% | 8% | 10% | 12% |
|---|---|---|---|---|
| 10 | $13,972 | $15,645 | $17,531 | $19,655 |
| 20 | $38,993 | $49,423 | $63,002 | $80,699 |
| 30 | $83,802 | $122,346 | $180,943 | $270,293 |
Along with time, compound interest is an investor's best friend. It can also be your worst enemy if you make minimum payments on credit cards and stretch payments out for decades. Friend or enemy? The choice is yours. To learn more about compound interest and the time value of money, review Unit 2, Investing Basics, of Investing For Your Future at www.investing.rutgers.edu.