As a millennial, you may feel that the cards are stacked against you. Between debt, an increased cost of living, and lower wages, it is hard to think otherwise. However, millennials have something at their disposal that puts them a leg ahead of the generations above them. It’s called compound interest, aka the 8th wonder of the world according to Albert Einstein!
Well, what is compound interest and why is it your best friend as a millennial?
Let’s break it down. According to Investopedia, compounding is “the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time. This growth, calculated using exponential functions, occurs because the investment will generate earnings from both its initial principal and the accumulated earnings from preceding periods. Compounding, therefore, differs from linear growth, where only the principal earns interest each period.”
Well, what really does that mean? Let’s use some numbers so dig into it. Say you have $1,000 and you invest in the stock market with a growth rate of 10% per year.
|Year||Compound Interest Total||Simple Interest Total|
As you can see, each year the growth on the investment increases because you are earning interest on both the initial principal and the past years earnings resulting in increased growth each year. But…. The trick is you have to reinvest the earnings from the previous years’ for compounding to occur. You cannot take the growth and go spend it. If you did spend the growth, then only the principal amount would be invested each year. That’s called simple interest which does not even remotely compare to the growth from compound interest as seen above.
Why Compound Interest Makes Time In The Market So Important
Due to the nature of compound interest, there are 3 real ways to affect the growth you can receive from compound interest.
- You can increase time in the market
- You can increase the initial starting dollar amount or payments you put in
- You can increase the interest rate you are receiving
Increasing any of those 3 would help maximize the growth of your investment.
So how does this apply to you as a millennial? Well, it’s simple. You have to control what you can control. And that’s time in the market. Your goal should be to start investing early so you can maximize the time your money has to compound.
Let’s look at an example that can help validate why time in the market is so important.
Say your goal is to have $1,000,000 saved by the time you retire at age 67. How much would you have to save each month at various ages to reach that goal?
As you can see from the chart above, there is a huge difference in how much you have to save based on when you start. If you chose to start saving at age 20, you would only need to save $319 a month to have $1,000,000 when you retire. But, if you delayed saving and did not start until you were 35, you would now need to save $864 a month just to reach the same desired end goal. That is a huge difference!
Compounding Works Both Ways
As you can see, compound interest is a powerful tool that when harvested properly can make a huge difference for you financially. However, it can also work negatively against you when the compounding occurs on debt. Say you graduated with $200,000 of student loan debt that has an interest rate of 4% and you choose to not start paying off that debt for a few years. At the end of year 1 that $200,000 becomes $208,000. Then at the end of year 2 it becomes $216,320. And lastly, at the end of year 3 the debt grows to $224,972.80. You now owe almost $25,000 more simply because you chose to delay paying off that debt. At all cost, try to not allow your debt to compound.
The Rule of 72
The Rule of 72 is a quick way to determine how long it will take for your investment to double at a fixed interest rate. I understand that interest rates change year to year, but for this example let’s just use 8% as the interest rate since that is the average of how the market does on a year to year basis after inflation. So, the Rule of 72 states that if you divide 72 by a given interest rate, the answer will show you how long it will take for your money to double thanks to compound interest. For this example, 72/8 = 9. It would take 9 years for your investment to double at an 8% interest rate if you leave your money and let it compound on a yearly basis. That is so powerful! Leave your money invested!
The moral of the story is that as a millennial, time is on your side. If you choose to listen to Einstein and harvest the power of compound interest, you will more than likely find yourself in a strong financial situation down the road. Just remember, time in the market is way more important than timing the market.
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Disclaimer: Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. For all of the disclaimers, please see my disclaimers page.