Popular phrases, such as "time is money" and "a penny saved is a penny earned," allude to the interrelationship of time and money. Even small amounts of savings, combined with a decades of compound interest, can grow to significant sums. Compound interest, very simply, is the calculation of interest on reinvested interest, as well as on the original amount invested.
Compound interest can be your friend...or your enemy. An example of the latter is someone who owes $10,000 on a credit card with a 17% annual percentage rate (APR) and a minimum payment of 2% of the outstanding balance. Assuming that only minimum payments are made, it will take 50 years to repay this debt and the total repayment would be $33,447: the original $10,000, plus $23,447 in interest, according to the book Slash Your Debt. The best way out of debt is to put time on your side by shortening the time it takes to repay it. This can be accomplished by negotiating a reduced interest rate with creditors (so that more principal is repaid with each payment) and/or paying more than the minimum due.
A dollar that is saved or invested wisely will be worth more in the future than it is today. Future value is the amount that a sum of money will be worth at a later date when it is compounded for a certain time period at a certain interest rate. The longer the compounding period, and the higher the interest rate earned, the larger its future value.
The Rule of 72 provides is a simple way to illustrate the impact of compound interest. To estimate how long it will take to double a sum of money (any amount), at a given rate of return, divide 72 by the interest rate. The result is roughly the number of years before an initial sum will double (i.e., the doubling period). Money will double in seven years at 10%, eight years at 9%, nine years at 8%, ten years at 7%, and 12 years at 6%. The Rule of 72 can also be used in reverse to calculate the interest rate required to double money. Simply divide 72 by the specified time period.
If the above numbers look impressive, consider how many doubling periods are available if someone starts saving a lump sum and/or periodic deposits in their twenties or earlier. At an annual return of 8%, a sum of money would double every nine years, with six 9-year doubling periods between ages 22 and 76. Saving early in a Roth IRA (Individual Retirement Account) fully maximizes the awesome power of compound interest. Contributions can be made up to the lesser of $3,000 (through 2004) or 100% of earned income. The beauty of starting a Roth IRA in one's teens (assuming there is earned income) is that, in most cases, little or no income tax is initially owed on the amount contributed because incomes are generally low. On the back end, it is possible to amass over $1 million tax-free at retirement.
For every decade that a person delays saving, the required investment needed to reach a specific goal approximately triples. Assuming an 11% average investment return, to accumulate $1 million at age 65 would require monthly savings of $67 at age 20, $202 at age 30, $629 at age 40, and $2,180 at age 50. The sooner one starts investing, the more money that is saved, and the greater the average annual return, the easier it is to accumulate a seven-figure portfolio.
Time also has another financial benefit: it reduces investment risk. Time diversification is the reduction in risk that accompanies the lengthening of an investor's time horizon. Historical investment data compiled by the Chicago investment research firm, Ibbotson Associates, indicate that time decreases the amount of volatility, or ups and downs in prices, of investments. In other words, the highs aren't as high, and the lows aren't as low, as an investor's time horizon increases.