The Myth of Compound Interest

Many people have heard the phrase “compound interest is the 8th wonder of the world”!

Wrong, for most people with little money saved up (most people have less than $10,000 saved for retirement), compound interest is basically worthless.

You won’t love compound interest unless you have a large amount of money already working for you.

For example, if you make a great 10% rate of return, but only have $1,000 in your investment account, you will have made $100.  That number grows to $1,000 if you had $10,000 and earned a 10% return. Still not going to alter your life too much.

One of my favorite reminders for clients is that if they want more money in their account a year from, “invest more money in them” as that is a much better way to insure a larger balance rather than relying on investment returns.

The real “8th wonder of the world” is a result of combining ongoing saving/investing with ongoing growth of what you put away.  This reminds me to emphasize the importance of setting up automatic investment plans (AIP’s).

AIP’s are the real key to growing wealth!

For many people their 401(k) works this way.  Thank goodness!

Another example, when each of my three children were born I started AIP’s in College 529 plans. I didn’t have much in my budget at the time, so each account began with an AIP of only $50/month. As my income went up, I increased the amount slowly, to $75, then $100, then $250, finally up to $500/month for each child.  By the time my kids were in high school, these accounts had grown to five and six figures and the compound returns were over ten thousand dollars some years! Now, I’m LOVING compound returns!

How did this work out for me? My wife and I had three kids in three years, and I currently have 2 kids in a college (DePaul and U. of Minnesota) and my youngest is a senior in high school. Thanks to starting early and automating, we ended up with well over $100,000 in each child’s 529 plan, never had to pay any income tax on the growth of the accounts and will be paying for all three kids college entirely from these accounts!

The compounding was super helpful for us, but only because we started early and keep increasing what we put away.

This is true today (start early and increase AIP’s) and always will be great advice for everybody.