How money works for you

How money works for you

Let your money work for you. All of us have heard that saying at some point, but what does it really mean?

For some of us, the idea of compound interest makes natural sense. If you put away money for a long time, it’s going to grow slowly at first, but over time it will grow faster and faster and faster. It is exactly that method that allows people who save a lot of money when they’re younger to become incredibly wealthy when they’re older.

Yet this picture is still one that many people have a hard time thinking about. Today, I’m going to walk you step by step through seven years of compound interest, just so that the idea is as clear as possible.

Let’s say that in one year – a year that we’ll call Year Zero – we save $100 a month. At the end of that year, we have $1,200 and we choose to put that money into an index fundthat returns 7% a year on average. In order to keep the calculations simple, we’ll assume that it’s a very steady 7% per year.

Let’s look at what happens in each subsequent year to that investment.

Year One

In the first year, your $1,200 earns a 7% return, which is $84. Thus, at the end of year one, you have $1,284.

Year Two

In the second year, your initial $1,200 earns a 7% return again, which is $84.

Also, the $84 you earned in year one earns a 7% return, which is $5.88.

You now have $1,284 – your total at the end of year one – plus your new $84 and your new $5.88, giving you a new total of $1,373.88.

It’s worth noting that in year two, your investment total actually went up by $89.88 instead of just $84 – it actually went up more in the second year than the first.

Year Three

In the third year, your initial $1,200 again earns that 7% return, adding $84 to your total. Also, the $84 you earned in year one and the $84 you earned in year two both earn a 7% return. Each one earns you $5.88, so the total of both is $11.76. The $5.88 you earned in year two also earns a 7% return, earning you another $0.41. Let’s break that down.

You have your initial $1,200. It earns you $84 this year, contributing a total of $1,284 to your investment total.

You have the $84 you earned in years one and two. Those each earn you $5.88 and together contribute $279.76 to your total.

You have the $5.88 you earned in year two. That money earns you $0.41 during year three and together they contribute $6.39 to your total.

Your total is now $1,470.05 ($1,284 plus $279.76 plus $6.39). Your investment earned $96.17 this year, more than the $89.88 of previous years.

Year Four

At the start of year four, you have $1,470.05 in your investment.

In your fourth year, your initial $1,200 again earns that 7% return, adding $84 to your total. Also, the $84 you earned in years one, two, and three each earn a 7% return, adding $5.88 to your total three more times. You earned $5.88 three different ways last year, so each of those returns 7% and thus each adds $0.41 to your total. You also earned $0.41 last year and that returns 7%, giving you another $0.06 for your total.

So, let’s work through all of this step by step.

You have your initial $1,200. It earns you $84 this year, contributing a total of $1,284 to your investment total.

You have the $84 you earned in years one, two, and three. Those each earn you $5.88 and together contribute $269.64 to your total.

You have the $5.88 you earned in year two and both of the $5.88s you earned in year three. Those each earn you $0.41 and together contribute $18.87 to your total.

You have the $0.41 you earned in year three. At 7%, that earns you another $0.06, contributing a total of $0.47 to your total.

The total of your investment now is $1,572.98. Compare that to last year, when the total was $1,470.05. In that year, your investment grew by $102.93, a better growth than the $96.17 it earned last year.

Let’s keep going!

Year Five

At the start of year five, you have $1,572.98 in your investment. Let’s work through the new growth step by step.

You have your initial $1,200. It earns you $84 this year, contributing a total of $1,284 to your investment total.

You have the $84 you earned in years one, two, three, and four. Those each earn you $5.88 and together contribute $359.52 to your total.

You have the $5.88 you earned in year two, both of the $5.88s you earned in year three, and all three of the $5.88s you earned in year four. Those each earn you $0.41 and together contribute $37.74 to your total.

You have the $0.41 you earned in year three and the three $0.41 returns you earned in year four. At 7%, that earns you another $0.24, contributing a total of $1.88 to your total.

You have the $0.06 you earned in year four, which isn’t big enough to earn a cent of interest on its own, so it just contributes $0.06 to your total.

The total of your investment now is $1,683.20. Compare that to last year, when the total was $1,572.98. In that year, your investment grew by $110.22, a better growth than the $102.93 it earned last year. Your growth is actually accelerating.

Let’s look at just one more year.

Year Six

At the start of year six, you have $1,683.20 in your investment. Let’s work through the new growth from this year.

You have your initial $1,200. It earns you $84 this year, contributing a total of $1,284 to your investment total.

You have the $84 you earned in years one, two, three, four, and five. Those each earn you $5.88 and together contribute $449.40 to your total.

You have the $5.88 you earned in year two, both of the $5.88s you earned in year three, all three of the $5.88s you earned in year four, and all four of the $5.88s you earned in year five. Those each earn you $0.41 and together contribute $62.90 to your total.

You have the $0.41 you earned in year three, the three $0.41 returns you earned in year four, and the six $0.41 returns you earned in year five. At 7%, that earns you another $0.60 ($0.06 apiece), contributing a total of $4.70 to your total.

You have the $0.06 you earned in year four plus the four $0.06s you earned in year five, which earns you $0.02 at 7% interest. That adds $0.32 to your total.

Now, the total of your investment is $1,801.32. Since you first deposited that $1,200 at the start of year one, your investment has grown by more than 50%. In just the last year, it jumped from $1,683.20 to $1,801.32, a growth of $118.12. Your rate of growth continues to accelerate.

Years Seven and Beyond

Want some peeks at what the total looks like in later years?

At the end of year seven, that investment will total $1,926.93.

At the end of year eight, that investment will total $2,061.82.

At the end of year nine, that investment will total $2,206.15. At this point, your investment is earning about $150 per year.

At the end of year ten, that investment will total $2,360.58. In other words, it will have basically doubled at that point.

At the end of year seventeen, that investment will total $3,790.58. In other words, it will have more than tripled.

At the end of year twenty one, that investment will total $4,968.67. In other words, it will have more than quadrupled. At this point, the returns are growing so fast that the investment is earning your initial $1,200 return every four years.

At the end of year thirty, that investment will total $9,134.71. That’s from simply saving $100 a month right now for just one year, putting it into your retirement account, and just sitting on it for thirty years.

Now, Think About This…

The honest truth is that you’re probably not going to stop contributing at the start of Year One. It’s likely that you’re going to keep saving $100 a month and contribute that at the start of each year.

What does that mean? At the end of year six, you would have contributed $7,200. The first $1,200 you contributed would now be worth $1,801.32. The second $1,200 you contributed would now be worth $1,683.20. The third $1,200 you contributed would now be worth $1,572.98. The fourth $1,200 you contributed would now be worth $1,470.05. The fifth $1,200 you contributed would now be worth $1,373.88. The last $1,200 you contributed would now be worth $1,284. Your total would be $9,185.43 – just from that initial $7,200. You’ve earned thousands in just a few years by only contributing $100 a month.

Assuming contributions keep rolling in at the same steady pace, the investment total is going to jump by thousands each and every year.

What does that look like after thirty years? Assuming you keep contributing just $100 a month to retirement, your total after thirty years of saving is $121,287.63. If you start withdrawing 4% a year after that, that’s a $5,000 a year supplement to your Social Security, turning a challenging life into a survivable and even enjoyable one.

Three Lessons

There are three big lessons to learn here.

First, saving early is the key. The earlier you can start socking money away for retirement or other big goals, the better. As you can see from this example here, the longer money sits in an account, the faster it grows in the later years just before you actually use it.

Second, saving consistently is almost as important as saving early. Just set an amount that you’re saving each month and forget about it. Doing that is a big part of retirement savings success.

Third, the way that wealthy people continue to build their wealth isn’t really a secret. They spend less than they earn, save the difference, and let the power of compound interest make it grow.