Building For The Future – Compound Interest

Financially Independent, Retired Early (FIRE) is all the rage these days.  There are articles, blogs, and podcasts galore that talk about it. Hey, this one too!  The Internet has enabled so many new ways to generate additional income through side hustles.  In addition, it is easier than ever to invest your surplus income, and have it work for you.  The concept of compound interest is critical to helping you achieve these goals.

A common question is “How much money do I need saved to retire?”.  This is the wrong question. Being financially independent is not a question of net worth.  It is fundamentally a question of cash flow.  Financial independence can be boiled down to having enough passive income every month to pay all of your expenses.  I say “passive income” because the idea is that you want to be free from depending on traditional employment to pay your bills, hence the independent part.

The more passive income that you can generate, the more lavish a lifestyle you can afford. Alternatively, the more frugally you live, the less you need coming in to be independent. Everyone has a different point because we all have different needs and wants.

There are two primary ways to achieve financial independence:

Create business ventures that deliver passive income

This may be a particular side hustle, such as a blog or rental properties.  Essentially, it is something other than a 9-5 corporate job that you depend on for income.  It doesn’t mean there is no work involved, so it may not be entirely passive.  Hopefully, if you are going this route, it is something you are excited about and putting in the time working it is enjoyable. It could also be a company that you started and are able to hand off to others to manage for you.

Passive income from investment returns

This is the mechanism that is most commonly referred to by the FIRE bloggers and podcasts. It is based on saving as much as you are able to build up a large investment account and then relying on periodic gains that provide cash flow for expenses.  This is the method that benefits from the magic of compound interest.

Often, people will use a combination of these methods.  It may be that you create a side hustle and instead of spending that money to live more lavishly now, you invest it.  Or, you may spend several years investing to reach financial independence and then use your free time to generate more revenue through a side hustle.  It’s really up to you what path works for you and how you want to approach life.

Magic of Compound Interest

What financial blog would be complete without at least one post that breaks down compound interest? It is fundamentally important to understand this. This is the singular most important concept behind achieving wealth. It also gives you a different perspective on how much something costs.

Let’s use a basic example, if I have $1000 and I invest it in an S&P 500 index fund.  An S&P 500 index fund is a mutual fund that basically owns some of every stock in the S&P 500 index, therefore it is well diversified.  No particular company will be able to wipe out your investment, but it will perform as well or poorly as the market as a whole.  On average, the S&P 500 provides a 7% annual return that has been adjusted for inflation.  This means that if the S&P 500 goes up 10% and inflation goes up by 3%, you actually have a 7% gain.  It is important to mention that this is on average, there are periods that are better or worse than others, including years which can be absolutely devastating. We will get into that deeper in a later post.

Back to our example, after the first year at 7% interest, our $1,000 is now worth $1,070.  We earned 7% on our %1,000.  In year two, our $1,000 is now worth $1,144.90.  We earned $70 in year one on $1,000 and we earned another $74.90 in year 2 on the $1,070.  Still does not seem very exciting, but this is why time is a critical part of the equation.  Let’s look at that same one-time investment of $1,000 over 10 years.

Now that looks a lot more interesting!  In 10 years, that $1,000 has effectively doubled, through no actual effort of your own. It is a set it and forget it way to grow your wealth.  If you extend the chart out, it continues to grow faster and faster each year, but I am keeping the timeframe for discussion locked at 10 years.

Are you going to retire rich off a single S&P 500 index fund of $1,000?

Absolutely, not!

However, the concept when applied to a more realistic ongoing level of investment such as a family with combined incomes of $80,000/year has an after-tax income of $72,000, or $6,000/month.  If your expenses are $3,000/mo, that means you can invest $3,000/mo.  In 10 years, you will have $497,392 in your investment account.  A 7% return on that account will provide $34,817 per year, which is just short of paying for your annual expenses.

What does it look like if I stop contributing after 10 years and let that money continue to build for another 5 years?  My $500,000 turns into $700,000 and will generate $48,000 per year instead of $34,000.

If I choose to keep investing the $3,000 a month for 5 more years, making it 15 instead of 10, I end up with $900,000 with annual returns of $63,325.

What if I decide to spend the next 5 years aggressively investing at $3,000/mo and then stop investing and just let that nest egg build on it’s own?  Well, after 5 years I will have $207,026.  In the next 15 years, that will build to $571,000.  That will return $40,000/year in investment returns.

There are a whole range of ways that you can build your investment strategy, each one with varying results.  The key is to get something built up early, so it can continue to build and work for you, effectively doubling every 10 years, even left entirely alone.

Changing Your Perspective on Purchases

This invites a new way to look at how you spend your money.  What is the impact of making changes in your lifestyle?  Well, that depends on what you do with those savings.  Let’s take a quick look at a couple of choices.

Should I keep my cable service?

I recently had cable service where I had a combination of cable TV and Internet, a couple of TVs in the house and a decent sized package of channels.  Everyone in the house had different shows they liked to watch, and it ended up being the largest package to get all the channels we all wanted.  The total monthly bill was $280/mo.  However, I realized that I could cut that down to $100/mo and get just the high-speed Internet and Netflix.  So, if I save the $180/mo and that instead into the S&P 500 index fund, instead of just spending it on other things, what is the net result?

The net result after 10 years? $31,155.27

Is wasting a ton of time watching mindless shows really worth that?  If I invested that money instead, my nest egg would be throwing off $2,180 per year in additional interest after 10 years.  Just for not having cable and using Internet and Netflix instead.

Should I get a dog?

This one is near and dear to my heart.  My 10-year-old daughter keeps begging me for a dog.  I did a bit of research into this and based on a number of pet sites, getting a good pure bred dog without any family history of medical issues will cost me $4,000 in the first year, including getting the dog from a breeder. The dog will then cost me approximately $2,000 per year in food, veterinary bills, and other assorted expenses.  This doesn’t include any high priced surgeries or other medical treatments.

The net result after 10 years? $31,576.20

Does this dictate my decision?  No, but at least if I decide to get her the dog, I will be going into the decision with my eyes wide open to the true cost.  This is to both my cash flow over the next 10 years and also the resulting impact to my investment account.

Your Own Excel Magic

Interested in working on different scenarios yourself?

The key Excel formula is the Future Value formula.

=FV(rate, nper, pmt, [pv])

Rate = Interest Rate Per Period (.07 Annual or .07/12 Monthly)

Nper = Number of Period

Pmt = Amount Investing Per Period

PV = Present Value, Used for Initial Investment

Investing $1,000 up front and letting it sit for 10 years at 7% interest?

=FV(.07, 10, 0, -1000)

Monthly cable bill reduction of $180 per month?

=FV(.07/12, 120, -180, 0)

Buying a dog that costs $2,000 initially and $2,000 per year?

=FV(.07, 10, -2000, -2000)

TIP – Set your Pmt and PV as negative values and the result will be positive.  Look at it from the perspective that the money is going out, so it is taking it away from your bank account into your investment account. The result will be positive, because the money is coming back to you.

Disclaimer: I am not a tax accountant, financial advisor, or lawyer.  The information provided above is intended to be informational based on how I analyze these investments.  No guarantees or predictions are made about inflation or investment and stock market returns.