» Strategies for Mutual Fund Investing » Compounding Interest Power

Compounding Interest Power

In order to better grab the real essence and power of compounding interest rates, we have created an imaginary situation. It will help you to understand the advantages and impacts of this type of interest on your money, which was classified by Einstein as the "8th wonder of the world."

Let's consider an example of two persons - Tom and John - who decided to secure their retirement years by two different approaches.  They both start with $30 000 for investment. Tom decided to invest them in a savings account, whereas John invested them in a mutual fund.

Tom had an income that allowed him to put another $30 000 into his savings account every year. John was not in a position to do so and so far it looked like Tom had the greater premise for secure retirement years.

We will make some assumptions for this example:

  • 3% inflation rate;
  • Tom's account makes the exact amount necessary for the coverage of inflation;
  • John's account makes 12% above inflation.

Table 1 represents the amounts of money that Tom and John have after a particular period of time based on the assumptions made above.

  Tom John
After 5 years $150,000 $47,206
After 10 years $300,000 $83,192
After 15 years $450,000 $146,612
After 20 years $600,000 $258,381
After 25 years $750,000 $455,356
After 30 years $900,000 $802,493
After 35 years $1,050,000 $1,414,267
After 40 years $1,200,000 $2,492,422

Who is getting less now?

40 years after their initial investment, the sum in John's mutual fund has grown to the outstanding $2,492,422 compared to the twice less $1,200,000 in Tom's savings account. What is the moral of the story? The lesson you should learn is that although Tom continuously invested his hard earned money in his account, he could still not get the same result as John. The latter was prudent enough to assess the power of compounding interest and by one-time investment to beat the savings account returns.

If Tom has followed John's example and has invested $30 000 annually in a mutual fund, Tom would have ended up with $ 28,565,800!

Another moral that you should extract from this story is that you should plan your financial future from early. This is so, because starting early and making the appropriate money contributions will lead you to better retirement years.

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