Published: Sun Aug 20 2023
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
Albert Einstein
Compound interest is probably the single most important thing to understand about finances. Sadly it’s also something that most people do not seem to understand at all.
In a nutshell, compound interest is a process through which the interest that you earn pays you interest.
If you were to invest $100 at a 5% interest rate, after 1 year you’d earn $5 and finish with $105. The next year however, you wouldn’t be earning interest on $100 anymore, you’re now earning interest on the new balance of $105, so you’d earn $5.25. Without ever touching that money again, you’d earn more and more money each year.
The longer that you’re able to leave that money invested, the more money the original $100 will have generated. If you leave it long enough, you’ll eventually have more than double what you started with.
Working backwards a bit it’s easy to see that life is actually much more expensive when you’re young. If you assume a retirement age of 62 (the earliest you can collect social security), then you’d be giving up 40 years of compound interest for every purchase you decide to make at 22.
At a 7% return, spending an extra $100 on coffee and donuts means having $1,875.50 less in retirement. What’s more, that missing nineteen hundred would have also been paying you $131.28 per year! Those are some expensive donuts.
The below chart shows what $100 spent on coffee and donuts could translate to in retirement, and the amount of yearly income that’d be achieved at a 7% interest rate.
| Age | Cost in Retirement | Yearly income at retirement |
| 20 | $1,875.50 | $131.28 |
| 25 | $1,322.98 | $92.61 |
| 30 | $933.24 | $65.33 |
| 35 | $658.31 | $46.08 |
| 40 | $464.38 | $32.51 |
| 45 | $327.57 | $22.93 |
| 50 | $231.07 | $16.18 |
| 55 | $163.00 | $11.41 |
| 60 | $114.98 | $8.05 |
| 62 | $100.00 | $7.00 |
The popular mantra “you only live once” often serves as justification for youthful spending habits. However, a closer examination reveals that it might entail ignorance about the trade-offs involved. When individuals declare a desire to enjoy their youth, it can sometimes be translated as “I am unaware of the potential sacrifices I am making, and I'm indifferent to their consequences.”
The aim isn't to discourage spending altogether. Understandably, you will need to spend some money to maintain a reasonable quality of life. The key lies in making wise choices and striving for efficiency. By delving into the implications of your expenditures, assessing the value they truly bring, and comprehending the trade-offs you are making, you pave the way for a financially conscious and prosperous future.