A hypothetical story about Jane, Mary, and compound interest
Jane and Mary were born the same year and grew up across the street from each other. Through childhood and college, they remained very good friends and they would stay up late talking about what they anticipated their lives to be like. They knew they needed to work hard, invest early for retirement, and let the compound interest work to their advantage. They both had the goal of retiring before they turned 66, but after college, their lives and lifestyles went in two different directions.
Jane and Mary’s parents had always taught them that if you are a steady saver, it can set you up successfully for comfortable retirement life. Therefore, both Jane and Mary were committed to contributing a steady annual amount of money to retirement accounts that earned a constant 10% rate of return on their investments. (This is a hypothetical example. Real world rate of returns varies with the market and investment strategies. This hypothetical story does not imply or guarantee returns.) However, Jane and Mary did not begin investing at the same time. They took two different approaches in their saving toward retirement.
Early in life, Jane’s mom taught her that over time compounding interest could have a big impact on her savings. When Jane got her first job. at age 22, she followed her mother’s words of wisdom and began contributing to a tax-deferred retirement account. She wasn’t making a lot of money, but as a savvy saver, she simply put 10% of her income ($2000 per year) aside for savings and lived a modest lifestyle on the balance. Oh yes, she had more than one Top Ramen dinner! However, she was young and enjoying her life. It felt ok to her.
After time Jane moved up the ranks at work and began making more money at her dream career. Within 12 years she realized she had extra money at the end of each month, and instead of continuing to save for retirement, she instead saved for a new car and later for a down payment on a house. She completely stopped saving in her retirement account! However, she did not take money out to supplement her lifestyle.
When Mary graduated from college, she still wasn’t ready to think about saving for retirement. She knew she should, but she wanted to buy nice clothes, a car, and travel with friends. She figured she would make up her savings shortfall later.
When Mary was 30 she married the man of her dreams and they had a child the next year. She took a break from work when her baby was born and was only ready to return to work on her 34th birthday. With a steady income, she now felt like she was ready to save, but her family had a lot of expenses. She put $2000 a year toward her retirement contributions and she continued to do so until she retired at age 65.
Jane’s strategy vs. Mary’s represents powerful compounding interest
What were the end results of Jane and Mary’s saving strategies? Jane only contributed for 10 years and Mary contributed for 32 years up until she retired before turning age 66. Mary had a lot more years making contributions to her retirement account, but Jane had more time for her money to make more money with the power of compounding interest.
Discover compound interest
Compounding interest allows a person to put their money to work. If a person earns interest on savings and investment, the interest received earns interest too. Investment money can grow rapidly like a rolling snowball and over time can swell to a large amount.
Two factors have a big impact on compounding interest. The first is the amount of interest earned. The higher the interest rate the more your money grows. The second is time. The longer your money is invested is directly correlated to growth potential.
Who had the most money at retirement?
Let’s see how these two saving strategies differed over time:
Do you want to play with different saving strategies? Check out this great compound interest calculator on investor.gov provided by the U.S. Securities Exchange Commission.
This story delivers a very important message about the power of compounding interest. Snowball-like growth occurs when interest compounds over time. Both Jane and Mary put the power of compounding interest to their advantage, but Jane had the added benefit of time on her side. Jane had considerably more money in her retirement account by age 65. She had accumulated $993,307 vs. the $442,509 Mary had in her account.
About the Author
Author, Marianne Martini Nolte, Certified Financial Planner ™ practitioner, provides fee-only, fiduciary, independent financial services. Her firm, IMAGINE FINANCIAL SERVICES (IFS) is a registered investment advisor offering advisory services in the State of California and in other jurisdictions where exempted. Marianne’s focus is serving Women and Young Professionals.
This article is intended as a high-level view. All written content is for information purposes only. Opinions expressed herein are solely those of IFS, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to other parties’ informational accuracy or completeness.