The Power Of Compounding Interest

Did you know that if you inherited a $100,000 IRA when you were one year old that IRA would pay out more than $8,000,000 over your lifetime?

Compounding interest is an amazingly powerful tool for building wealth. Almost all wealthy people have used compounding interest to work for them in one way or another. Whether it be stocks, bonds, CDs, or mutual funds, you should get your money working for you as early as possible.

Often when I mention the folly of not investing extra money into some sort of compounding investment early in life I get mixed responses. Some don't comprehend the magnitude of an opportunity like that. Some think numbers that enormous can only be a scam. Some are apathetic and just don't care. But then there are some that see the opportunity and take advantage of it. I hope you are one of those people.

Compounding interest is the best way to build wealth because it is easy. There is no effort involved in making the principal accrue interest and build itself. Granted, you have to work hard to earn that principal but look at it this way. Say you are 21 and you have $40,000 in savings. You want to buy a new lifted truck because you hear paying cash is a great way to save money not paying interest. This scenario is to illustrate the power and importance of compounding interest. Here are two options and the results they will give:

Option 1: Buy the truck outright with the cash. Let's imagine you would have had to pay 9% on that loan. Over a period of 5 years you would have paid $9820.05 in interest.

Woohoo! That's great. Let's see what you would have made if you would have invested the $40,000 in a retirement account and taken out a car loan.

Option 2: Invest the $40,000 at 9% in a ROTH IRA and take out a car loan at 9%. You might think they would just cancel out, but you would be wrong. Here are the numbers:
You spend 5 years paying off your new truck and pay out $9820.05 in interest. While you paid off your loan your IRA was busy making money babies. Over 5 years that invested $40,000 has made you a fat $61,544.96 . That is a profit of $11,724.91 (with the interest subtracted). But since that money is staying with you it continues on making money far past the loan maturity date.

To summarize that scenario, over 20 years, when you are 41, you would have a comforting $224,176.43.

I do not suggest trying to retire on only $224,176. I do suggest using this principal of compounding interest while you are young so that you don't have to work so hard as you get older.

Here is your very own calculator so you can figure out what your savings could do for you.

Financial Calculator

What have your experiences been with saving and investing? Sound off!