How compound interest works (and why starting early matters)
Compound interest is the reason a 25-year-old who saves a little can end up wealthier than a 40-year-old who saves a lot. Here is the math, in plain English.
There is one idea in personal finance that does more work than any other. It is compound interest. If you understand it, the rest of investing makes sense. If you do not, you will keep wondering why people who earn less than you somehow have more than you.
The plain-English version
When you save or invest money, it earns a return. Next year, the return itself starts earning a return. The year after, the return on the return starts earning a return. Money makes money, and that money makes money.
This is not exciting in year one. It is not exciting in year five. It becomes outrageous around year twenty.
A concrete example
Two people, both invest $300 a month. Both earn an average 7% per year (roughly the long-run stock market average after inflation).
- Anna starts at 25. Stops at 35. Ten years of saving. Total invested: $36,000.
- Ben starts at 35. Saves until 65. Thirty years of saving. Total invested: $108,000.
Who has more at age 65?
Anna does. By about $40,000. She put in a third of the money. She ends up ahead because her money had thirty extra years to compound on itself.
What this means for you
You cannot make up for lost time by saving harder later. You can only make up for it by giving money more time. The single most valuable thing you can do for your future self is start now — even with a small amount.
If you are 25, $100 a month is more powerful than $1,000 a month at 50.
What this does not mean
It does not mean compound interest is magic. It only works on money that is actually invested and growing — not money sitting in a checking account earning 0.01%. It also works against you when you carry debt at 22% interest on a credit card. The same force, pointed the wrong way.