Compounding interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it. Compound interest is the most powerful force in the universe.- Albert Einstein.
Despite my track record, this is a real quote. It teaches us a few things. 1) Albert Einstein was clearly a little sexist- women can compound interest too. 2) He was clearly prone to exaggeration-Really? Compounding interest is more powerful than anything in the universe? Oh I’m sorry…black holes. Slap. Really, Albert. 3) Understanding compounding interest is important.
(For the examples below I will be using the term “He” but in a very non-sexist way, unlike certain people.)
We typically deal with compounding interest in one of two ways- debt and investments.
When we buy something with money we don’t have, we pay using credit. This is how most of us pay for things because we already don’t have any money because of what we bought last month. People are willing to keep selling us stuff because they’ll be charging us interest. This is good for them because we end up paying much more than the original sticker price.
When you invest your money, you are the one getting paid the interest. This is fun because it has the opposite effect as debt in that you end up with a lot more than the original amount you put in.
A hypothetical situation that in no way is meant to shame anyone in particular even if they just bought a $50,000 truck and know Mr. Burrito Bowl personally…
Person A buys a $50,000 truck and makes payments, Person B invests the same amount, and Person C buys a more affordable truck and invests the difference. For this comparison I’ll use an interest rate on the loan of 2.99% and I’ll assume an ROI (return on investment) of 7% the investments.
To play with the numbers yourself go to:
I know this SOUNDS boring, but I promise there are pictures.
Person A- $50,000 loan at 2.99% APR and the loan is for 7 years.
For the $50,000 truck person A will pay $660.44/month for seven years for a grand total of $55,476.93.
Here are some pictures incase you don’t believe me. Which, you know what? You shouldn’t need to look at these pictures in order to believe me because I’m a trustworthy guy. I think it says more about you if you feel like you need to check my work, but here you go.
Person B- Invests $55,476.93 over seven years
Let’s assume Person B puts that same amount of money into his investment account, buying low-cost index funds. He’ll start with $0 and put $660.44/month for seven years.
At the end of seven years Person B has over $70,000 saved up while Person A has a seven year old truck and zero dollars saved up.
But, Person A at least has a truck and Person B wouldn’t have a vehicle in this scenario. Since not having a vehicle feels like it isn’t an option for most of us let’s introduce Person C.
Instead of buying a $50,000 truck, Person C buys a $5,000 truck and invests the rest.
Person C- Spends the first eight months paying off his $5,000 truck at $660.44/month and the remaining six years and four months investing $660.44/month into low-cost index funds earning a ROI of 7%.
At the end of seven years Person C has a very old vehicle and $63,303.61 saved up.
Person A and Person C get to let their money keep compounding. In fact, if Person C put no more money into his investments (but lets that initial seven years keep growing) here’s where he’d end up in twenty years.
So maybe you don’t want to drive a $5,000 vehicle around your entire life. Maybe that trade off just isn’t worth it. What if you took the next seven years and drove a less expensive vehicle but put a more expensive vehicle payment into your retirement accounts?
If you just did that one time then let it sit for twenty years you’d have more than a quarter of a million dollars. Compounding interest is apparently more powerful than a black hole so let’s look at what would happen if you left that quarter million alone for another twenty years.
What if you just kept letting it sit there for a total of forty years instead of twenty?
Total after forty years: $1,032,571.23
If you made that one decision it could fund your entire retirement. Let that sink in. Let’s say when you’re eighteen-years-old you have the chance to buy a $50,000 truck. Instead of doing that you put that money into your retirement account for seven years but never invested a single penny again.
Once you turn twenty-five you’re able to spend whatever you earn because you already have your retirement taken care of.
That’s the power of compounding interest.
What did we learn?
-Just because you can afford the payments doesn’t mean it’s a smart business move.
-Investing a little early is worth way more than investing a lot later.
-Buying a $50,000 vehicle when you’re young could be the difference between having your retirement fully funded and turning 65 with nothing in the bank.
-Albert Einstein has some work to do with being not so sexist.
-My screen shots are very informative and impressive.
Here’s a few more articles about money you might like:
How Investment Fees Are Decimating Your Portfolio
Why Pursue Fi- The Pros and Cons of the Frugal Lifestyle
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I think the silent key here is when you are starting out (or just dont have your sh*t together yet)….opt for the no car or the very low cost car. Once you have your ball rolling pretty nicely…the diminishing returns on $ makes it so you COULD buy a $50k car without borrowing money…not that you should buy such an expensive extravagance. There are plenty of very useful and nice brand new or slightly used trucks for well below that.