No sources have been able to confirm that Albert Einstein actually named compound interest ‘the most powerful force in the universe.’
It’s safe to assume that Einstein’s line of work put him in contact with more fascinating formulae than simple exponential theory.
Nonetheless, there’s no denying the staggering power of compound interest in the world of finance. Applied to debt, compound interest can cripple you. But applied to your savings and investments, you can actually make it work in your favor.
Imagine a reverse credit card debt. Imagine your bank paying you a ‘minimum payment’ bill every month towards a debt that never really seems to get smaller. At the receiving end of that, you’ll feel like a winner.
But what has this got to do with the right time to start saving and investing? Let me explain.
Credit cards work on compound interest, which means that you owe your bank a little bit more with every day that you continue to carry debt.
Similarly, your savings portfolio can also give you compounded returns. Invested in the right places over say, your entire working life, even relatively small monthly savings can compound and grow exponentially, leaving you with a hefty sum at retirement.
Now your short-term goals for your savings might vary. You might want to buy a house, or maybe a car. Ideally, your financial advisor should help you identify your short and long term financial goals and timelines, so you can understand and manage them wisely.
In the long run, however, the ultimate goal of saving and investing your money is achieving total financial freedom. In other words, canceling out the need for you to work to earn money.
The goal is to make your money work for you. You have a few options on how you can go about making that happen, and compound interest plays a key part in the process.
Understanding Compound Interest
You could have a fixed deposit, where you put in a fixed amount of money, lock it in for a fixed period of time and make a fixed annual return on it. That’s simple interest and it’s great, but it bars you from harnessing the exponential returns of compound interest.
Compound interest, essentially, is the concept of earning interest on interest. Over time, your returns grow exponentially, because the interest you earn keeps getting added on to the principal amount, pushing your next round of returns even higher.
This works a lot like the snowball effect – the roll of money keeps rolling, and over time it gathers momentum and keeps getting bigger and bigger at an increasing rate.
There’s a reason why Warren Buffett’s biography is called ‘The Snowball’.
So when should you really start saving?
Yesterday. Or as soon as possible.
Compound interest works best when it has time on its side. This is why you would have heard or been advised to start investing as early as possible. You could potentially start saving from your first paycheque onwards, and ideally, you should.
Even if you manage to invest $300 per month, over 25 or 30 years, compound interest will snowball your savings into a significant chunk. Here is a quick graph to explain how much you need to be putting away every month, in order for your savings to touch the $1 million mark at retirement. So if you’ve steadily been saving about $300 a month since you hit 20, then you’re headed towards that million!
The funds available to you for investing might be much larger than $300 per month, and then, of course, you would be looking at proportionately larger returns. But the reality is that you might have other financial obligations – bills, expenses, mortgage, school fees, and the seemingly important non-essentials too, that are all vying for that money.
It is a good idea to keep a close watch on your monthly expenses, clearly differentiate between needs and wants, and arrive at a sum that you can comfortably invest every month or every year. That amount will depend on your current financial standing.
Read: With investing, the sooner you start the better, provided you’ve built a sound financial foundation to build up from.
Building the Foundation
It is ironic, yes, but you need to achieve some form of financial security in the present to be in a position to start building financial security for your future.
Whilst many of us want to start cashing in the returns right away, it might be worth considering, for instance, that investing while you still carry high-interest debt completely negates your returns.
Credit cards fall under this category. If you have outstanding credit card debt, the right thing to do would be to clear that debt completely before putting your money towards savings.
Similarly, investing when you don’t have an emergency fund also means that you might have to tug at that investment when a crisis hits. You should ideally have enough of an emergency fund to get you through three to six months without an income.
That way, if you lose (or quit) your job, or have an unexpected financial emergency of any kind, you don’t have to nip your investment in the bud or mid-bloom and lose out on the benefits of compounding returns.
Ready, Set, Invest
Once that base is built, you have no outstanding high-interest debt and have stashed away a generous emergency fund, you’re ready to start investing.
“The sooner you start investing, the better” does hold true, but the fine print that goes under that advice is, “provided the investment isn’t going to cause you financial or emotional distress.”
Once you get started from that strong base, though, the right investments will unlock the potential of what compound interest can do for your savings over time.
Take a look at this article on How Much You Need to Save To Have $1 Million At Retirement. That’s where I’ve shared the ‘millionaire at retirement’ graph from, and that, right there, is compound interest at work.
Unless you have a thorough understanding of your investment options and potential returns, it might be worth speaking to your financial advisor about the best short, medium and long-term investment options that you have available to you.
Since time literally is money, in this case, you probably don’t want your money to be sitting in the wrong pot another day.