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The Myth of Compound Interest


Financial planners, educators and parents tout the magic of compound interest. You’ve probably been told dozens of times about the miracle of compound interest: systematically saving a small amount of money over a long period of time will make you a millionaire in the future, thanks to compound interest.

But the magic of compound interest is a myth. The reason it’s a myth is because other things like bank fees, taxes, varying interest rates, and inflation eat away at the slowly building sum.

Financial planners love to promote the power of compounding because it seems so sensible. You don’t have to be rich or know much about sophisticated investing systems. The basic idea is that in saving slowly and steadily, your savings grow not only from the money you save but in the compound interest return as well.

Simple compounding grows your savings dramatically—in a perfect world. Using an online compound interest calculator to calculate the sum you’ll have in the bank over 40 years if you put $250 per month into savings at an extremely optimistic 7.5 percent annual return and you’ll have a gross return of nearly $900,000.

Except you won’t have that, really and here’s why:

Factor in a varying annual return and the fees associated with the investment. At best, the cheapest investment fees are 0.5 percent annually. That’s more than $100,000 in fees over forty years. At worse, your investment could earn far less than the projected average annual return of 7.5 percent, affecting the power of compound interest.

Then there’s the average annual inflation rate of three percent. The $900,000 value calculated is now cut in half.

It’s not over. You will owe taxes at some point. Whether upfront to in forty years, expect another chunk to go to the IRS.

And lastly, people historically are not fond of saving. There’s just too many things to buy and ways to spend that money. Few are you willing to give up on wants today to save for a goal as far as forty years away. Math calculations, like the compound-interest example above, are rarely inspiring enough for such a lifestyle change.

So is compound interest worthwhile at all? It is, especially as part of an overall retirement strategy. There are other investment opportunities that can provide a higher rate of return faster. But often, the higher rate of return you’re after, the more risk. That’s why it’s important to have a diversified portfolio that you’re contributing a monthly amount to grow. If you’re in your peak earning years you can take lessons from compounding interest to save more and accelerate your path to retirement.

Easy adjustments to your saving schedule can boost the power of compounding. Be wary and vigilant of fees. And scheduling your monthly contribution at the first of each month instead of on the last day, can add thousands to your bottom line.

 

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