The magic of compounding interest: Sure path to FIRE (financial independence retire early)

 

Money growing over time

Albert Einstein: “Compound interest is the eighth wonder of the world.  He who understands it, earns it...he who doesn’t...pays it.

This quote is one of my favorites of all time.  It sums up the basic tenet of investing which allows early retirement to work by growing money over time.  It also underscores an important lesson which is also important to grasp, which is, don’t owe money to anyone, as compounding interest will make your life absolutely miserable, as money you borrow will get bigger over time!

I, along with my wife, are one of many adherents of FIRE (financial independence retire early) movement, and we can proudly say we’ve seen the power of compounding interest first hand. 

What is compounding interest?

Compounding interest is the addition of interest to the principal sum (loan or deposit), basically adding interest on interest.  This happens when interest is reinvested rather than paid out, thereby the interest earned next pay period is the sum of the principal sum plus the previously added interest payment.

In simple terms, if you have $100 deposited, on the first month you would get $5 for interest if interest paid 5%.  You would then have a total of $105.

On the following month, you would get $5.25 interest on $105 for a total of $110.25.

Compounding interest unfortunately doesn’t look like much when you’re dealing with hundreds of dollars or even thousands of dollars.  But imagine this concept applied to tens or hundreds of thousands dollars.  You’ll quickly see how powerful this truly is.

I had my first ‘taste’ of compounding interest when I was in my twenties.  I had a credit card debt of about $20000.  This was the result of going to a computer technology school (tuition) to get a computer certification, as well as bad budgeting.

I spent countless hours trying to move this debt from one credit card company to the next.  I would open up the latest credit card offer to transfer debt for introductory rate of 1.9% (for the x number of months).  It seemed paying near minimum amount each month didn’t make a dent in that $20000.  In fact, it kept getting larger every time I looked at the credit card statement.  What I also realized, too late of course, was that there were added transaction fees when moving debt around.  This fee can be as much as 3-4% of the amount.  

The compounding interest on my original $20000 would just snowball into larger and larger size.  It felt like an 800 lb gorilla was sitting on my shoulders.  I felt guilty carrying this debt and I felt depressed knowing there was no happy ending to this ballooning debt...

Long story short, I learned my lesson.  Once I paid that debt off, I vowed I’d never use credit cards so recklessly.  No more booking $3000 trips to Cancun just because I’m stressed out.  No more retail therapy because I deserve it. 

These days I make sure I pay off the entire amount each month.  No more paying interest on interest every single month!

How does compounding interest help ME achieve financial independence?

Charlie Munger, who is the right hand man of Warren Buffett ‘the Oracle of Omaha’, once said:

The first $100000 is a bitch.

This quote is a practical statement about investing but it’s so true that it hurts.  Compounding interest really kicks in AFTER your first $100k but not much before that.  For your first $100k, compounding interest has little power.  Most of the heavy lifting is done by you, by saving money diligently.

Here’s an example below on how long it takes for you to reach your first $100k if you started from $0 and were saving $1000 each month:

  1. Year One:  $12000
  2. Year Two:  $24960
  3. Year Three:  $38956.80
  4. Year Four:  $54073.34
  5. Year Five:  $70399.21
  6. Year Six:  $88031.15
  7. Year Seven:  $107073.64
It takes about 7 years to reach your first $100k.

Now if you continued this path by continuing to save $1000 every month, this is how long it takes to get to $200k:
  1. Year One:  $127639.53
  2. Year Two:  $149850.69
  3. Year Three:  $173838.75
  4. Year Four:  $199745.85
It takes another 4 years to reach $200k.

Let’s do one more by going to $300k:
  1. Year One:  $227725.52
  2. Year Two:  $257943.56
  3. Year Three:  $290579.04
  4. Year Four:  $325825.37
It takes little over 3 years to reach $300k.

By the way, if compounding interest did NOT play a role in these scenarios, your principal amount would only be $180k at the end of 15 years.  This is the true power of compounding interest!

Your ‘original’ or principal amount is $180k, but you end up with over $300k with compounding interest.  This is how early retirement is possible.  

This compounding interest works faster and faster the more money you have.  It starts a snowballing effect beyond the first $100k.  Notice it took about 7 years to reach the first $100k.  It takes another 4 years to get to the next $100k, but only about 3 years to get to the next $100k!

The following conclusions are helpful in your journey to reach your financial independence:
  • Save as much money as you can in the beginning.  Do whatever you need to do to get to your first $100k.  Work a second job, a third job, side hustle, gig, etc., and put away as much as possible to get to your first $100k.  Remember, the first $100k is really going to be done by you and not by compounding interest! There’s just no substitute for putting away your own money at first.
  • Once you get to your first $100k, keep pushing forward!  It’ll get easier to get to your second $100k.
  • Continue to push forward until you keep hitting the next goal(s).
  • Important note:  Reducing your expenses will help your quest tremendously!  If you can reduce your spending, that means you can put away more towards retirement.  This is how you retire early, by reducing your spending while growing your investments!  
  • After about the 13th year, the investment growth will really kick in where the money you earn from investments will be greater than the money you put in.  Even knowing this, keep the pedal to the metal!  Don’t let up.  Always remember the more money you can put away towards the beginning, the better...
  • Snowballing effect of compounding interest takes awhile but when it starts, you’ll really enjoy the ride!  The important thing is to keep putting away money into the snowball so it becomes a bigger snowball!
Please use this ‘eighth wonder of the world’ to YOUR advantage and not for someone else like credit card companies, banks, etc.  Once you grasp the beauty of compounding interest, you’ll be well on your way towards your goal of reaching financial independence.

I thank you for reading!

Jake

Wandering Money Pig 


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