“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Who said that? I have no idea. People attribute it to Albert Einstein, but the truth is he probably didn’t say it either. In fact, people quote Albert Einstein a lot when he didn’t say the majority of those things. It’s simply trying to add more weight to whatever they are saying.
“A blind cow can still produce milk.” – John Smith
“A blind cow can still produce milk.” – Albert Einstein
See? By the way, I just made up that phrase right now. I hope it isn’t a real quote.
However, the quote does have its own wisdom. Compound interest is so powerful that calling it the eighth wonder of the world is reasonable… and may even be an understatement. The second part of quote is 100% true though, you are either reaping the benefits of compound interest or you are paying it to someone else.
Here is a quick example:
You have $1 in the bank. You put away $18,000 of money away every year ($1500 a month) and it earns 7% interest every year, compounding yearly (for simplicity), and you do this for 30 years. In your head, estimate how much you have after 30 years. You can even round up to $20,000 if you want.
How much did you guess? Well, 20,000 x 30 is 600,000. So assuming the 7% interest I think $1 million is a reasonable guess. I would agree completely. And we’re both wrong… oh so wrong.
Plug in the numbers: 1, 1500, 30, 7%. And hit Calculate. And… $1,700,301.77… That is $700,000 more than you would have guessed… 70% more than your guess. Yes, you put in $600,000 but you gained $1.1 million in interest over the 30 years. This is why compound interest is the eighth wonder of the world. I understand how it works and even I can’t guess (very accurately) how much it would be.
Why did I choose the numbers of $18000, 7% and 30 years? Well, it wasn’t for no reason at all. The IRS limit for contributions to a 401k/403b OR a 457 is $18000 a year, in pretax dollars. 7% is a reasonable return over a long period of time (30 years) if you invest in low cost index funds. If you are a pessimist you can use 5 or 6% or 8% if you are an optimist. 30 years is a good amount of time for a career, especially if you assume a doctor will begin their first “real job” around their early 30s, with an aim to retire around 65.
So go ahead and play with the numbers. Let’s keep the 7% and 30 years the same, but change the $18000 to $36000, because you are lucky enough to have both a 401k/403b AND a 457. How much does that extra 18k a year help? Well, our previous guess was $1 million for the $18,000, so let’s just double that guess and make it $2 million, and then because we know compound interest works, let’s just assume we make another $1 million.
Run the numbers… 1, $3000, 7%, 30 and… $3,400,595.92. So even when we just added a crazy amount of money to what we already thought was a lot, it was STILL less than the actual compound interest.
You put away $1,080,000 and have $3,400,595.92.
That is the beauty of compound interest.
Now, remember you need all three of these elements. Money, Interest Rate, and Time. Of these factors which is the most important? It’s hard to say….but I would venture to say its probably time.
Let’s say you finish residency and get your first job but you “forget” to put away money for the 1st 10 years. (Please don’t do this!) Then the kids are all in public school and you are the height of your earning and you have extra money to put toward investments. Lucky for you, you are partner in your private practice and can put away $52,000 pretax (I’ll explain this a little more later). So you decide, ok great, I’ll just put away my $52,000 a year for the next 20 years, I’ll be fine.
Run the numbers… 1, $4333.33, 7%, 20. It’s… only $2,131,767.83.
You put away $1,040,000 but only have $2,131767.82.
Those lost 10 years HURT and you can never get them back. You can’t control your interest really because you should be investing in index funds anyways and whether you get 6% or 8% isn’t really up to you. You can always put away more money (albeit taxed if you already max out your pretax options). But those years of not putting away money is lost. Those pre-tax dollars are lost. It actually hurts more than what I am stating above because the extra $52000 you saved the first 10 years was also taxed and you probably only got about $30000 after taxes to use. Like the quote above says: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Don’t pay compound interest. Earn it.
Start saving early and often. You survived just fine as a poor college student and resident. Grow into your money slowly. Your first priority should be to maximize and optimize your pretax accounts, hopefully with some form of employer match.
If you never have that extra money in your account, you won’t miss it, trust me.
One last example:
Your friend, Johnnie, from high school didn’t go to medical school. He didn’t go to college either. Johnnie went to trade school and became an electrician. He went to go to work for his dad at 20 and made a very reasonable $70,000 a year. Johnnie’s dad was also very smart and told Johnnie to max their 401k, so he did. So Johnnie lived on $52,000 pretax salary. Lucky for him he was in a low cost-of-living area and he was able to do this. Johnnie worked for 30 years and his 401k now sits at the healthy $1,700,301.77 I stated above. At this point he decides it’s time to go part-time so he stops contributing to the 401k, and then fully retires at 65, 13 years later.
Run the numbers. $1,700, 301.77, 0, 13, 7% and… $3,344,750.93
Johnnie has almost as much as you do (maxing both 401k/403b and 457) at retirement than you even though you put away way more money ($540,000 versus $1,080,00) and you both did it for 30 years. Yes he worked more years than you, but he was part-time for the last 13 years.
You are both 65 and have $3.4 million for retirement.
Save early, save often. Just by being a doctor… you are WAY BEHIND.
Compound interest is almost always worth more than you think it is.
Don’t pay compound interest. Earn it.
You can not control interest. You can always put away MORE money. But you never get that time back.
Save early, save often. Just be being a doctor… you are WAY BEHIND.
Agree? Disagree? Questions, Comments and Suggestions are welcome.
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