Wes Moss: The power of compound interest

Certified financial planner Wes Moss provides personal finance advice and accessible investment strategies. His guest post appears here weekly.

Wes Moss hosts 'Money Matters' Sunday mornings on AM750 and 95.5FM News/Talk WSB

Wes Moss hosts 'Money Matters' Sunday mornings on AM750 and 95.5FM News/Talk WSB

The Money Matters’ Facebook page is a great way to keep tabs on what concerns Atlanta’s investors. We get all sorts of questions and comments about the hottest issues of the day – ETFs, the Euro Zone crisis, investing in gold, tax issues, etc. And, every now and then we get questions like this:

“Which would you choose: 25 cents per hour for life, or $10,000 today?”

Because I am fully committed to my Facebook relationships, I decided to fire up my trusty Excel spreadsheet and provide a detailed answer to this query. I used the following assumptions: “life” means 60 years, and the money would be invested for those six decades earning an average 5 percent return over the years. I think the numbers will surprise you – even if you’ve guessed the answer.

Obviously, the $10, 000 lump sum is the better deal at the outset. But after just 45,409 hours – that’s 5.18 years — you break even. From that point forward the 25 cents per hour begins to outpace the $10,000. At the end of the 60 years (525,600 hours) at 5 percent compound interest, the quarter-per-hour totals $835,963.84 while the $10,000 has grown to just $200,854.80.

As long as you live more than 5.18 years, the quarter per hour is a no-brainer.

This out-of-left-field question offers a reminder that compound interest is, well, awesome – especially when applied over time. Twenty-five cents an hour dropped into coffee cans over 60 years would total $131,000. But when the power of compound interest is applied, that nest egg totals more than $800,000.

So get that spare change out of the coffee can and into something that will harness the power of compounding:

  1. Sign up for the automatic savings feature of your employer’s retirement plan (401k, 403b, etc.). Increase your contribution each year by 1 percent or 2 percent until you are making the maximum contribution allowed — $17, 000 if you are under age 50; $22,500 if you are 50 or over.
  2. Open a Roth IRA and contribute as much as possible every year. The Roth rules allow a maximum annual contribution of $5,000 for those under age 50, and $6,000 for those 50 and over. Before you contribute to a Roth make sure you meet the income eligibility requirements.
  3. If you still have money to sock away after funding your 401k and Roth IRA, start an automatic investment plan with a low cost index mutual fund or ETF. Look at Vanguard’s Dividend Appreciation fund (VDAIX) or ETF (VIG) for a long list of U.S. companies that pay dividends.

I suggest you start out by putting $182.50 in this account every month. That’s just 25 cents per hour.

Which would you choose…and why?

– By Wes Moss, for Atlanta Bargain Hunter

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18 comments Add your comment

David Patson

June 11th, 2012
5:46 am

The real hidden fact here is not the power of compounded interest, but rather how many hours there are in a year. If the original question had been “Would you rather take $10K lump sum or receive $2190 per year?” the answer would be more obvious. Sometimes we just don’t realize the size of numbers. Here’s another one for you. (Not factoring for taxes or compounding interest) How much money would Mark Zuckerberg have to receive for every hour of his life to be worth $17B at the age of 28 years? Answer: over $69,300 per hour, for every single hour of his life. Which is over $19 per second, for every second of his life. (First!)

nelsonho

June 11th, 2012
6:02 am

First, 5% is not paid for interest, it is .20%. Some stocks pay 5% and more. That allows for the investment to appreciate and the interest paid to compound or to be reinvested in stocks. Anybody that spends carefully and saves will have a nice net worth over time whether they get compound interest or not. It is a person’s way of life that is far more important than compound interest that determines how much they are worth over time.

Joe Blow

June 11th, 2012
6:33 am

Where are you going to get 5% interest?! The banks are paying .2%

Redo your math with real numbers.

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wolfman

June 11th, 2012
12:35 pm

dale pues

June 11th, 2012
12:39 pm

Joe Blow is dead on the money. Your example is severly flawed. There isn’t a bank in the country paying 5% interest, even on jumbo cd’s with a five year term (http://www.bankrate.com/cd.aspx). The banks are making out like bandits of course, borrowing money at less than one percent and loaning it out at five percent and (especially on credit cards and personal loans) much higher. So I would say give me the $10,000 and I will look for an investment that will maximize my return, something that would at the very least match inflation.

Shane

June 11th, 2012
3:23 pm

I know, right? Where’s this magical 5% and how can I get a piece of that action. I was fine and well with 2% cd’s for some of my ‘gauranteed’ investments – sure I’d like the 10-30% the market was capable of in years past, but 2% will do. If you can even find a bank willing to give you 1%, good for you – but you’ve probably had to dump 10-20k into a 2 year cd to even get that – wasteful investment at best considering it won’t even begin to keep up with inflation (and I mean REAL inflation – not what rich people are telling you) and you’ve locked up a large sum of money you could invest more wisely.

I think Wes is dead on with investing/paying yourself, of course – but I think he’s missing his audience – if most of us were offered 10k or $0.25 an hour we’d be a fool not to take the 10k and PAY OFF OUR DEBTS! Wes over here is probably in the black, but 90% of his audience has massive debt – and their financial health would be WAY better served by taking out the debt than it would be by gambling… which is essentially what Wes is suggesting. You only gamble when you can afford to lose and not before such time. Kill your debt, then save. If you can’t kill your debt, all the saving in the world won’t help.

If you’re already out of debt, then sure, listen to Wes. But if you’re already out of debt, chances are, you don’t need financial advice… or you’re 12 years old.

A serious question

June 11th, 2012
3:27 pm

Lets face it: interest rates (except on junk bonds) are pitiful, the stock market is floundering. There are no safe havens (Defined as: “as safe as U.S. Treasuries over the last 50 years”) anywhere in the world that where returns are greater than the rate of inflation. For the last 5 years, compounded rates of return on gov’t bonds and bank CDs are not significantly different than stuffing cash in a mattress.

bob

June 11th, 2012
4:11 pm

Wes,

The correct way to evaluate the question is by discounting back the revenue stream of $.25 per hour for life (you define life) at an appropriate discount rate (again your discretion). Compare your result to the $10,000. By doing so, you will be comparing today’s dollars with today’s dollars.

No sense getting all worked up about Wes’ choice of 5% as his target rate of return. He is demonstrating the power of compound interest. We all understand that the “power” diminishes to nothing as interest rates approach zero.

Shooter McGavin

June 11th, 2012
4:54 pm

A more visual way to look at the power of compounding is by using one of Dave Ramsey’s investment calculators on his website. You will see very quickly how the value of your monthly contributions (the “principal”) is dwarfed by the value of interest and/or dividends paid by stocks/ETFs/Mutual Funds you own, compounding at 9% annually (historical return of S&P500 since 1950s).

We sure don’t live in the perfect world of a spreadsheet, but it makes the case for finding good dividend stocks to dollar-cost average over many, many years of saving.

jnes

June 11th, 2012
5:22 pm

Would you rather take $10,000 now risk free or gamble your quarter a day on any of the stock market based retirement funds.

There are no guarantees with 401ks or IRAs. You could lose it all.

T.Ryan

June 11th, 2012
11:30 pm

For those of you that are questioning his 5% interest rate, you soon forget that high yield money market accounts were in the 4% in 2007. The average return for a aggressive growth fund over 30 years was 8.9%. The average consumer memory is 5 years, that’s why people are complaining about a 25 basis point jump on a 30 year mortgage to 4%. Have you forgotten that the annual avg on a 30 yr mtg in 2006 was 6.41%

The Gambler

June 12th, 2012
2:29 pm

Anything that you can make 5% is great with compound interest. I love compound interest….again Wes your right about it. However there is not one thing that gives a five percent interest on anything. This has really happened since around 2004-and on by most banks that it is only around 2 to 3 percent. Please don’t mislead folks you have some good things to say. Don’t say its magically there give them some places to go to find this five percent.

JT

June 12th, 2012
10:01 pm

The other misleading portion of this article is the unsolicited advice on where to invest. IRA, 401K, etc. are great but they virtually all invest in highly correlated stocks. It would be better to invest in alternative investments (rental property, land, etc.) which are historically very affordable.

NativeAtlantan

June 13th, 2012
9:54 am

0.2% interest? We all should have some cash in a savings account for emergencies. But we are actually losing money since inflation is higher than that.
If you’re looking for decent returns even in a stagnant stock market, check out the dividend yields of these bellweather stocks:
PFE: 3.97%
JNJ: 3.78%
MCD: 3.21%
KO: 2.73%
WMT: 2.35%
HD: 2.26%

And to jnes, you’re not going to lose it all. Stocks aren’t going to zero. In fact, over a couple of decades, the stock market is the closest thing there is to a guarantee.

Ole Guy

June 13th, 2012
4:29 pm

Believe it or not, 5% rates ARE out there. When maturity rolls around, a serious sit down with your friendly banker just might yield a few surprises. THE BANK wants to keep your deposits, while YOU, on the other hand, have the option of transfering funds from one institution to another. Do your homework, do the research, and you may be pleasantly surprised.

Jm

June 15th, 2012
1:21 pm

Irrespective of the market return, the only correct way to properly evaluate this question is to discount the cash flows and determine the net present value. We could debate the interest rate and personal investment preferences but this is simply a math problem asking is the NPV of .25 for life greater than a lump some of $10,000. It not a an equation that is debatable but rather one that could easily be proven by doing rather simply math. Not sure where Wes came up with the arbitrary 60 year figure.

Down3a

June 17th, 2012
4:56 pm

where can I get guaranteed 5% returns? I need some return, quick!