The Power of Compound Interest

by Kate on November 13, 2010

in Money

Warning! This post contains numbers!…but stick with me, there’s an important message here on why you should respect your savings. I hope you find it rewarding.

We all know that simply saving 10% of your salary isn’t going to get you out of the rat race anytime soon, but here is an example to make you realise the power of compound interest, and convince you to start saving as much as you can immediately. The moral of this story is that saving a little more now could mean having a lot more later!

I want you to picture in your mind two brothers, twins in fact, Ned and Phil, who are very different from each other. Ned leaves school at 16 with only the minimum education and Phil leaves at 25 with a PhD. To help you remember who’s who, NEd = No Edcuation and Phil = PHd, clever eh?

Aged just 16 Ned gets a job and although not well paid he manages to save £1,000 per year. Ten years later, aged just 25 Ned begins a family and is no longer able to put by £1,000 per year. In total Ned has saved £10,000. However he doesn’t spend the money and leaves it untouched until he reaches 65.

Phil as we know is the clever one and stays in school until finally getting his PhD aged 25. Aged 25 Phil now also starts to save £1,000 per year. Because Phil has a better paying job he continues to save £1,000 per year, even when having a family, and saves £1,000 every single year until he reaches 65. Over the course of his life Phil has saved £40k vs. Ned’s £10k.

Now let’s assume that the interest rate is a constant 10%. Still with me, let’s recap…

– Ned has saved £10,000 by saving £1k per year from 16-25

– Phil has saved £40,000 by saving £1k per year from 25-65

– The money is invested at a 10% interest rate

At age 65 who do you think has the most money? Would you think I was crazy if I told you that Ned had almost 50% more than Phil even though Phil saved 4 times more money? You Would think I was crazy, but you’d be wrong. Take a look at the following diagram, or work it out for yourself.

In fact, no matter how long Phil puts his £1,000 away for, he will never catch up with Ned. This is because compound interest is growing Ned’s money faster than Phil can possibly save. Who would you rather be, Ned or Phil? We’re not trying to knock the value of a good education, but if you want to be like Ned then start to curb your consumerism and start saving now – it will make a big difference later.

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