The power and peril of compound interest

  • February 13, 2017

By Byron Moore, posted February 13, 2017

Originally published in the News Star and the Shreveport Times on Sunday, February 12, 2017.

Q: I have always had a goal to have $1,000,000 in my investments. I’ve been at it for a while and I’ve finally gotten to $100,000 but that only puts me a tenth of the way there. I’m in my mid-30s and I don’t see how I’ll ever get there.

A: You need to understand the power of what you’re dealing with, but you also need to understand its potential for peril.

compound interestI’m talking about compounding interest, something Albert Einstein is often credited with calling “the eighth wonder of the world.” That’s probably an urban legend, by the way. A bit like Abraham Lincoln always complaining that his Twitter account kept getting hacked.

What we do know about compound interest is its power over long periods of time.

Let’s suppose Justin decides to save $300 a month. Each year he gets a 3% raise, so he is able to increase his monthly deposit by the same 3%. So in year two, he can save $309 a month; then $318 per month in year three and so on. Let’s optimistically assume he finds a mutual fund that earns him 7% per year.

At that pace, it would take Justin about 14 years to reach the $100,000 mark. If Justin had his eyes on $1,000,000 (as you do), he could be pretty discouraged. But Justin is the kind of guy who doesn’t give up, so he perseveres. By now, he’s saving $440 per month (he’s saving 3% more each year, remember).

At year 20, Justin reaches $200,000 (almost). Deep sigh. Anyone can see he’s a loooong way from $1,000,000. But he perseveres.

By year 30, he’s got almost $500,000. By now Justin is in his 50s. He wanted to have $1,000,000 by the time he quit working, but he can see that his working years are way more than half way done. But he perseveres. With his annual 3% boosts to his saving rate, he is now saving $700 per month.

When Justin is 64 years old, one year before his planned retirement, he opens his account statement to see what he’s been working towards all his life – he has his $1,000,000. It took him 39 years, but he made it.

What can we learn from Justin’s story?

Time. Compound interest takes a long time to work its magic. Justin only had $100,000 after 14 years. It took 35% of the time to get the first 10% of the results. Compound interest is not a get rich quick scheme.

If Justin had delayed just five years, those five years would come off the back end, not the front end, of his results. He would not have had 40 years for his systematic savings to work but 35. And those five years would have cost him $250,000.

Temperament. You’ve got to have a long-term, disciplined approach for compound interest to work in your favor. If you procrastinate, or are easily discouraged by market fluctuations, the whole program will break down for you.

Taxes. I did not factor taxes into my example above. It’s time to do that. Taxes can have a devastating impact on the compounding of interest. If you a have to pay taxes every time your account makes money, you not only have a compounding of the interest, but also a compounding of the taxes you pay as well.

I recall a conversation I had with one prodigious saver in his late 40s who told me he had saved so much money that his entire earned income was going to pay the taxes on his investments. While this was an extreme case, it illustrates how taxes actually grow as a problem when you have an increasing amount of taxable investments.

For this reason, many turn to tax deferral accounts (IRAs, 401Ks and annuities). But it’s important to realize this isn’t making the tax problem go away, merely deferring it to a future date. Many hope their taxes will be lower in that future, but there is no guarantee that will be the case.

Our national debt is fast approaching $20 trillion. Our federal government spends $500 billion more than it takes in each year. I’m not making a prediction, but it is at least a possibility that somebody is going to raise taxes some time to deal with this issue.

It may be wise to diversify your approach to dealing with the compounding of the taxes, just as you should diversify your approach to the investments that cause those taxes.

Yes, compound interest has significant power and potential over time. But you’d better also be aware of its side effects and have a diversified strategy of how to deal with them.

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