A Crazy Kid with a Crazy Idea
I loved mangoes when I was a kid, and still do now. When I learned that this sweet golden bundle of deliciousness came from trees, my naïve mind came up with a crazy idea.
What if we have our own mango tree!?
One day, I hastily consumed one, ran outside with the seed and started digging with my tiny hands until it was deep enough to cover the mango seed. That seed would not grow, but in my head, I could not wait for the day when I can just pluck and eat as many as I can, and I will live devouring mangoes happily ever after.
Today, I am still that kid with the crazy ideas. But this time I want something more than mangoes, more than stuff or money, I would say. I want to take back our time. We want our freedom.
They say that money does not grow on trees, but what if it can grow like one? Would it be possible to grow your own financial independence tree so you can live happily ever after on it?
In this post we will find out how this is possible through compound interest.
What is Compound Interest?
Compound interest is when you earn interest on your money together with the accumulated interest that it earned. It is gaining interest on the interests you received. Ancient Babylonians called it “şibāt şibtim” which is literally “interest on interest” when they conceived it almost 4000 years ago.
This method of accumulating interest makes your money grow exponentially. It grows while you work your 9-to-5 and even while you sleep. Albert Einstein most famously stated that compounding interest is the most powerful force in the universe. I believe him. He was literally a genius after all.
To see it in action, let us see what happens if we invest $1000 on an account that will give us 10% interest compounded yearly and leave it there for 20 years.
On Year 1 our investment will earn 10% of $1000, which is $1100. Making this our new amount.
On Year 2 the interest will be calculated on that new amount ($1100 + 10% of $1100 = $1210). Every year this will go on, as long as we have money invested.
|Years||Total Contributions||Future Value|
|Year 0||$ 1,000.00||$ 1,000.00|
|Year 1||$ 1,000.00||$ 1,100.00|
|Year 2||$ 1,000.00||$ 1,210.00|
|Year 3||$ 1,000.00||$ 1,331.00|
|Year 4||$ 1,000.00||$ 1,464.10|
|Year 5||$ 1,000.00||$ 1,610.51|
|Year 8||$ 1,000.00||$ 2,143.59|
|Year 11||$ 1,000.00||$ 2,853.12|
|Year 12||$ 1,000.00||$ 3,138.43|
|Year 17||$ 1,000.00||$ 5,054.47|
|Year 20||$ 1,000.00||$ 6,727.50|
We will not see significant growth for a few years, but in the 8th year our investment will double, it will be three times in 12 years and almost seven times its value in 20 years. This is not doing anything aside from saving and investing $1000 and letting compound interest work its magic.
Compound interest is not an overnight, too-good-to-be-true, get-rich-quick scheme. It is slow in the beginning and is quite boring, like watching grass grow. But after the momentum builds up, you will see how it accelerates your FI. Just be patient.
The Time Value of Money
This Old Chinese proverb beautifully touches on the Time Value of Money. This concept states that the sum of money you have today is worth more than the same amount in the future because the money you have now has the potential to earn more in time.
To take advantage of this wonder of an invention you must have time on your side. The sooner you start saving and investing, the more accumulated interest it earns. You go on with your day as usual (wake up, work, sleep, repeat) and your money will do the growing for you, if you don’t touch it until it is ready.
Although younger investors do not have a lot of money to invest, time is the most powerful edge they have. More chance for the seedling to grow roots, strong trunk and sturdy branches that would bear luscious fruits of financial freedom.
|Starting Age||Initial Investment||Monthly Contribution||Interest Rate||Money at Age 60|
As you can see on the table, a kid fresh out of college, earning less and therefore saving less, will have more money than someone in their 40s, earning more money and saving twice as much, when they both retire at 60
Like my mango tree, it will take time for you to enjoy your fruits after planting the seed and that is what a early investor has. It requires a little bit of your attention and a lot of your patience to see this through.
Rate of Return
The next important factor to compound your money is the rate of return. This is the measure of your earnings as a percentage of your investment.
Clearly, a higher rate of return will result to faster growth of your money, but chasing high returns also comes with higher risk.
At the writing of this post, the interest rates for savings accounts on brick-and-mortar banks are at 0.01%, online banks are at 0.40 – 0.60%, while CDs are at 0.50 – 0.60%. These returns are okay, but we thought that our money would be put to better work invested in the stock market.
In the stock market, you do not earn a set interest rate, but rather a return based on the change in the value of your investment. If you keep your money and the returns invested, it will grow over time the same way as interest is compounded.
We chose to plant our FI seeds on the U.S. total stock market that average 8 – 12% annual growth. Advise on where to put your money is beyond the scope of this article. Please take time to do your own research before you invest. Keep in mind that higher returns always bring higher risk.
Our Financial Independence Tree
On our previous article, When Can I Retire?, we found out that we are set to reach financial independence in 13.5 years, but did not factor in growth from compounding interest.
Let us factor that in. What will be our new timeline if we invested the majority of our 2019 Net Worth ($46,104.55) in a U.S. total stock market fund with a projected 10% rate of return compounded annually while contributing $7395 monthly.
When we factor in compounding interest, we are looking to reach financial independence and retire in 9 years (4 years earlier). If we choose to work until the 13th year, we will have almost double our FI number. This is because our money would grow at an accelerated rate as we continue to reinvest earnings to get additional shares and compound them with our monthly contributions.
This is the miracle of compounding interest. No wonder Mr. Einstein dubbed it the Eighth Wonder of the World and man’s greatest invention. It is a powerful force to grow your wealth if you have the commitment to see it through.
You don’t have to save thousands of dollars to take advantage of compound interest. Saving a little bit, early and often can put this strong wind behind your sails towards your journey to financial independence.
Are you ready to plant your retirement tree? The best time to start is NOW. Fertilize your savings with compounding interest. Watch it grow patiently and with perseverance. You will enjoy the fruits of financial freedom in no time.