Chanukah is one of my favorite holidays. I love retelling the story of the miraculous Maccabean victory over the much larger and stronger Seleucid Empire’s army to recover Jerusalem and rededicate the Second Beit HaMikdash. I also love commemorating the miracle of one small jug of oil that burned in the menorah for eight straight days by consuming delicious oily delicacies like potato latkes and jelly donuts.
As we celebrate all the wonders of Chanukah, it’s a great opportunity to also celebrate the many miracles in our daily lives. In the field of personal finance, this includes the miraculous power of compound interest. Albert Einstein was purported to have said, “Compound interest is the eighth wonder of the world…he who understands it, earns it; he who doesn’t, pays for it.” So what is “compounding” and what makes it so wondrous? Put simply, it is when the interest one earns on their money is reinvested and generates additional interest. The cycle of continuing to earn interest on your growing account balance is known as “compounding.”
To illustrate how compounding works, assume you worked for 40 years and saved $5,000 every year until you retired. All the money you saved was invested in a mutual fund that tracked the performance of the 500 largest U.S. stocks (i.e. the S&P 500), whose annual return, historically, is approximately eight percent. By the time of your retirement, you may have over $1.5 million. This may sound miraculous, but it’s just math. If you were able to increase your annual savings to say $20,500, which is the maximum allowable employee contribution to a 401(k) corporate retirement plan starting next year, you would end up with over $6.1 million by retirement using the same time horizon and return assumptions.
Some readers may be concerned about putting all their money into the stock market since its fluctuations can be nerve-racking. If this is your concern, it may be appropriate to implement a more conservative portfolio with some exposure to high-quality bonds that aren’t as volatile as stocks. This lower risk strategy may result in more modest returns. Revising the scenarios above to assume a six percent annual return over the 40-year time horizon, the $5,000 annual saver would still end up with approximately $870,000 at retirement and the $20,500 annual saver may end up with over $3.5 million. Investors can tinker with the various assumptions using a financial calculator or online tool to get a sense of their potential future nest egg. The important takeaway is that even if you save a relatively modest sum of money every year, by letting it continue to “compound” over an extended period of time you could end up with a meaningful sum of money by the end of your career.
The best way to seamlessly benefit from compound interest is through automation. If you have a retirement account at work, you can set up your contributions to be systematically taken out of your paycheck without much effort. You may also be able to sign up for “automatic escalation” where the amount you contribute can go up every year, allowing you to effortlessly save more money as your salary increases. People who don’t have access to a corporate retirement plan can still establish these automations by working with their financial advisor. The combination of a simple process to save money and a prudently designed portfolio will increase your chances of financial success.
“Compounding” is a double-edged sword. As Einstein noted, it can be devastating for those who don’t appreciate its impact. This is particularly true when it comes to credit card debt. It’s common to use a credit card to buy goods, but it’s extremely important to pay your bill on time and in full so interest doesn’t accumulate. According to WalletHub, the average credit card interest rate is a staggering 18.24 percent a year. A $10,000 credit card balance that isn’t paid down can grow to an over $285,000 balance over 20 years through the power of compound interest. That level of debt may be insurmountable for many. If you have any concern about being able to pay off your credit card bill in full, then don’t use it in the first place. The harsh reality is that credit card debt is a cancer to your finances and should be avoided at all costs.
Compounding can either buoy investors to financial success or it can be ignored and lead to financial ruin. It’s important to appreciate this concept and harness its power for good.