One of the key pieces of financial independence is compound interest.
The money that is invested generates interest. Those interests in turn generate more interests.
Your money works for you
If we invest 100€ with 10% returns we will have 110€ at the end of the year. We have got 10€ extra. If we reinvest everything, in the second year we don’t get 10, but 11. That extra euro has been generated by the 10 euros we got from interest in the first year.
When you invest money in the long term, time is a very important factor because it allows us to take advantage of the benefits of compound interest. Furthermore, some products delay the payment of taxes, so the money that would be destined to taxes is also generating interest. This is the case of pension plans or investment funds in Spain.
What impact does compound interest have on your savings?
To see what impact compound interest has in the long term, let’s do a quick case.
Let’s assume a monthly investment of 300 euros for 40 years. Let’s say that the annual returns are 7%.
In the following graph the sum of the contributions (those 300 euros per month) appears in gray. The green part is purely generated profitability. The difference is about 800k.
You can think of the gray part as what you would have after 40 years if you put 300 euros a month under the mattress.
For the most conservative of you, I have also prepared the graph with a 3% return. The result is a difference of about 300k.
It is important to realize that the environment is constantly changing. A few years ago 3% deposits were everywhere. But someone who decided to only invest in fixed-term deposits today would be receiving less than 1%.
I think it’s worth to maintain flexibility. Reevaluate our decisions from time to time can save us a lot.
Some final considerations
- I’m not considering inflation. A million dollars buy you much less today than 40 years ago. What will inflation be like in 40 years? I have no idea. You can base yourself on the projections of an investment bank, central banks, etc. It will be the best estimation but still not very reliable. If you want to have a laugh look at the projections of these same banks before any crisis.
- Returns are not fixed. In the graphs I consider that returns are always the same: 7% or 3%. This is not true in real life, the returns fluctuate like crazy. And fluctuations has a big impact in compound interest.
- Contributions do not have to be very large. It does not seem that 300 euros per month is an exaggeration. However, being constant for 40 years (rain or shine) is a challenge.