This one simple concept could change your life. Forever.
Albert Einstein called the deceptively simple concept the "greatest mathematical discovery of all time." We call it a path to financial independence.
Welcome to the miracle of compound returns.
In a nutshell, it's about interest, and how earning a slightly higher rate of interest can make a massive difference to the amount of money you end up with in the long run.
How does it work, you ask? Like this:
- You earn some interest.
- Next year, you earn interest on that interest.
- The year after, you earn interest on the interest on the interest.
- The year after that… and so on…
- You live financially happy ever after.
Rates Matter, A Lot
More than anything else, interest rates determine how quickly and how much your savings grow. The higher the rate at which you invest, the more – and the faster – your savings will grow, which is why you should make every effort to get the highest possible rate.
Since words cannot adequately describe the magical nature of compound returns, let's try a few visuals.
Here's how a single $1,200 investment grows over time in three savings scenarios.
How a single $1,200 investment grows
| 2% | 5% | 9% | |
| Initial investment | $1,200 | $1,200 | $1,200 |
| 5 years | $1,325 | $1,532 | $1,846 |
| 10 years | $1,463 | $1,955 | $2,841 |
| 15 years | $1,615 | $2,495 | $4,371 |
| 25 years | $1,969 | $4,064 | $10,348 |
| 30 years | $2,174 | $5,186 | $15,921 |
| 35 years | $2,400 | $6,619 | $24,497 |
| 40 years | $2,650 | $,8,448 | $37,691 |
As you can see, simply socking away one lump sum and doing nothing else, could turn $1,200 into nearly $40,000 over 40 years. Not only have you earned interest, but you've earned interest on your interest. And all you had to do was invest your first pay cheque.
That said, let's be honest: $37,691 ain't what it used to be. So let's make one small revision and invest $1,200 every year. Behold compound interest in a mildly caffeinated state…
A more compelling table than the previous one
| 2% | 5% | 9% | |
| Initial investment | $1,200 | $1,200 | $1,200 |
| 5 years | $7,695 | $8,494 | $9,674 |
| 10 years | $14,865 | $17,803 | $22,713 |
| 15 years | $22,782 | $29,684 | $42,775 |
| 25 years | $41,174 | $64,200 | $121,136 |
| 30 years | $51,829 | $88,899 | $194,211 |
| 35 years | $63,593 | $120,423 | $306,646 |
| 40 years | $76,582 | $160,656 | $479,642 |
Now we can see a path to almost half a million bucks. Not bad, right? Still, you should be able to top it. In fact, it's not a massive stretch to get near that magical $1 million milestone.
Just save $2,500 a year (a mere $208 a month), and at 9% you've got a million dollars in 40 years. Or stick with the $1,200 annual contribution but improve your rate of return. If you are able to earn a 12% rate of return, the $1 million prize is yours.
And the best part about compound interest is that it works the same for everyone, whether you have $20 to invest or $200,000. Go ahead, tinker with this compounding calculator to see what we mean. If you don't believe you can become a millionaire with just the resources you have right now, keep reading.
The amazing tale of the Mississippi washer woman
Oseola McCarty was born in Mississippi in 1908. For nearly 75 years, she lived in the same simple house, washing other people's clothes for a living and putting whatever money she could into savings accounts at local banks.
In the summer of 1995, Oseola made local and then national headlines when she donated $150,000 to the University of Southern Mississippi to establish a scholarship fund. "I just figured the money would do [scholarship recipients] a lot more good than it would me," she said. It soon came out that this washer woman had managed to amass nearly one quarter of a million dollars over her lifetime.
Time — a key part of the compounding equation — helped turn her meagre early investments into hundreds of thousands of dollars.
We like this ending better
As remarkable as the Oseola McCarty story is, the ending could have been a blockbuster. After she died in 1999, one of her bankers wrote to us saying: "Time was able to turn even the modest returns of her early investments into hundreds of thousands of dollars. If we had been able to introduce her to equities earlier, she would have left millions instead of thousands."
Remember, the amount you save and your time horizon — how long you have until you need the money you've invested — are only two-thirds of the compounding equation. Oseola excelled in both. But she did pay a price for ignoring the rate of return on her investments.
This might cost you hundreds of thousands of dollars
Typically, the more risk you are willing to take on (by, say, investing in shares rather than a savings account), the higher your potential return. But risk is a four-letter word to a lot of folks: They're happy to settle for lesser returns to avoid it.
But the avoidance of any sort of risk might end up costing you hundreds of thousands of dollars over a lifetime of saving and investing. Safer investments, like term deposits, not only return less than the share market, they barely keep up with the rate of inflation, and that means your retirement dollar is not going to go as far as you think.
As you'll find out over the course of these 13 Steps To Financial Independence, we Fools believe the best place for your long-term savings is the share market.
Your golden ticket to financial independence
There you have it: Financial independence is just three variables away. So start saving now (as much as you can), and invest it well. Because the sooner you get the wonder of compounding returns working for you, the sooner you'll reach your financial dreams. And that's exactly what this series will help you do.
Action: Who wants to be a millionaire? That's what we thought. Here's the magic code you need: 10,000, 8, 400, 35, 0, 0, 0. Plug in those numbers — in that exact order — here.
