Why the Tortoise Wins the Race: An Explanation of Compound Interest

Investments: Compound Interest

By Dr. Crystal D. Gifford, CFP®
Full-Time Faculty, Kaplan University  
Published March 2016

Many people claim to know and understand the power of compound interest, but if we really understood it and how capable it is of changing lives, we would use it more powerfully. Einstein is said to have called compound interest the eighth wonder of the world.  This statement is not only warranted, but if we would embrace its power and actually save the money we have been encouraged to save by financial planners, our entire lives and that of our children would be forever changed. 

In his book, The Richest Man in Bablyon, George Clason speaks of saving in terms of “one tenth of what I earn is mine to keep.”  In the book, he highlights the impact saving just a small portion of income can have on creating wealth. The key here, though is that “to keep” means to save to a point that the interest earned on the money saved also begins earning interest, known today as compound interest.  Clason referred to this as the gold coins having baby silver coins who eventually grow up and have their own coins until the value of the babies outweighs the value of the original gold coins set aside. 

Planning for Savings

When planning for saving, one needs only to focus on the power of growth and the concept of time.  The more time, the more powerful the growth that can occur. The other concern is interest rates earned (or rate of return).  The higher the rate earned, the faster the money grows. Of course, there is a concern for the amount of risk we take on as we earn higher rates of return, so one must explore this when making specific investment choices. 

To put this in perspective, let’s take a look at an example written in my book, The Money Shot:  The Professional Athlete’s Financial Playbook to Make the Big Time Last a Lifetime. Going from this example, let’s assume that we are planning to invest $250,000 per year for five years and then never invest another dollar after that, but do not withdraw either, for 30 years. The results you see are an account balance of over $18 million even though the actual deposits were only $1.25 million. Imagine that power as you review this sample excerpt from the book.  

 

Deposit

Interest Earned 10%

Account Balance

Year 1

$250,000

25,000

$275,000

Year 2

$250,000

52,500

$577,500

Year 3

$250,000

82,750

$910,250

Year 4

$250,000

116,025

$1,276,275

Year 5

$250,000

152,628

$1,678,903

Year 6

$0

167,890

$1,846,793

Year 7

$0

184,679

$2,031,472

Year 8

$0

203,147

$2,234,619

Year 9

$0

223,462

$2,458,081

Year 10

$0

245,808

$2,703,889

Year 11

$0

270,389

$2,974,278

Year 12

$0

297,428

$3,271,706

Year 13

$0

327,171

$3,598,877

Year 14

$0

359,888

$3,958,764

Year 15

$0

395,876

$4,354,641

Year 16

$0

435,464

$4,790,105

Year 17

$0

479,010

$5,269,115

Year 18

$0

526,912

$5,796,027

Year 19

$0

579,603

$6,375,629

Year 20

$0

637,563

$7,013,192

Year 21

$0

701,319

$7,714,512

Year 22

$0

771,451

$8,485,963

Year 23

$0

848,596

$9,334,559

Year 24

$0

933,456

$10,268,015

Year 25

$0

1,026,801

$11,294,816

Year 26

$0

1,129,482

$12,424,298

Year 27

$0

1,242,430

$13,666,728

Year 28

$0

1,366,673

$15,033,401

Year 29

$0

1,503,340

$16,536,741

Year 30

$0

1,653,674

$18,190,415

Total Saved

   $1,250,000

 

 

Now, having seen this example, we know that the average person does not have $250,000 to put away each year, but what if that was $2,500 per year. In this case, $12,500 would have grown to $181,904.15. Still not a bad deal. Next let’s add to that the possibilities if you would have put away that same $2,500 EVERY year for the entire 30 years. Imagine the growth that could occur. 

Next time you are going out for a $4.50 Starbucks coffee, ask yourself if you have saved just a little bit back this month and consider for every coffee you also put away an equal amount in saving for your future. Just $5 a day is $150 per month and $1,800 per year. Start today and be consistent. That is all that is required to take advantage of the power of compound interest. Your future self will thank you greatly!

This article serves as general information and should not be relied upon alone as official tax or financial advice. For application to your individual situation you want to be sure to consult your personal professional financial advisor. 

 Dr. Crystal D. Gifford is a faculty member at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.

References

Clason, George. (1955) The Richest Man In Babylon. Hawthorn Publishing. 

Gifford, Crystal D. (2016) The Money Shot: The Professional Athlete’s Financial Playbook to Make the Big Time Last a Lifetime. Morgan James Publishing.   



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