Magic Dollars and the Most Powerful Force in the Universe

It’s been just over a century since the great Albert Einstein successfully predicted how gravity works and now we’ve confirmed he was right. What’s that got to do with personal finance? Gravity has long been held as one of the most powerful forces in the known universe but there’s a force that’s even more powerful. A force whose power you can choose to harness for yourself. A powerful force others will harness against you if you let them. This force’s name? Compound interest.

The Magic Dollar

That right there is no regular dollar and not just because it’s got a picture of yours truly on it: it’s a magic dollar. What makes it so magical? Unlike the dollar you spent on that candy bar you bought at the grocery store from the impulse aisle by the checkout stand this dollar can actually work for you. It’s a stalwart employee that never asks for time off, never calls in sick, and never asks for more pay. Instead it sits there, earning small increments of additional money for you one percentage point at a time. How can you hire an inanimate object to serve as your employee? With the power of compound interest.

Compound interest is interest paid to you based on the amount of money you’ve set aside into your investment account. It’s different than simple interest which simply pays you a specific amount of money based on an initial investment into an account. Let’s look at an example. Bill has $1,000 to invest for 12 months. In a simple interest account he’s promised 5% for investing those thousand dollars each month meaning every 30 or so days he’ll have an extra $50.00 in his account. When a year has gone by he’ll have $600 more dollars than when he started. This chart shows what that growth looks like.

Month	Initial Investment	Monthly Addition	Total
January	$1,000	$1,000 X 5% = $50	$1,050
February	$1,000	$1,000 X 5% = $50	$1,100
March	$1,000	$1,000 X 5% = $50	$1,150
April	$1,000	$1,000 X 5% = $50	$1,200
May	$1,000	$1,000 X 5% = $50	$1,250
June	$1,000	$1,000 X 5% = $50	$1,300
July	$1,000	$1,000 X 5% = $50	$1,350
August	$1,000	$1,000 X 5% = $50	$1,400
September	$1,000	$1,000 X 5% = $50	$1,450
October	$1,000	$1,000 X 5% = $50	$1,500
November	$1,000	$1,000 X 5% = $50	$1,550
December	$1,000	$1,000 X 5% = $50	$1,600

In a compound interest account Bill gets to hire those dollars he’s getting paid in interest and put them to work for himself. They’re magic dollars, after all! This time he has the same $1,000 to invest and he’s getting the same 5% in interest but it compounds meaning each month the money being put into his account takes into account the total amount of money in the account, not just the original investment amount he put in himself. Let’s see how that impacts his total take home from the investment.

Month	Total in Account	Monthly Addition	Total
January	$1,000	$1,000 X 5% = $50	$1,050
February	$1,050	$1,050 X 5% = $52.50	$1,102.50
March	$1,102.50	$1,102.50 X 5% = $55.13	$1,157.63
April	$1,157.63	$1,157.63 X 5% = $57.88	$1,215.51
May	$1,215.51	$1,215.51 X 5% = $60.78	$1,276.28
June	$1,276.28	$1,276.28 X 5% = $63.81	$1,340.10
July	$1,340.10	$1,340.10 X 5% = $67	$1,407.10
August	$1,407.10	$1,407.10 X 5% = $70.36	$1,477.46
September	$1,477.46	$1,477.46 X 5% = $73.87	$1,551.33
October	$1,551.33	$1,551.33 X 5% = $77.57	$1,628.89
November	$1,628.89	$1,628.89 X 5% = $81.44	$1,710.34
December	$1,710.34	$1,710.34 X 5% = $85.52	$1,795.86

When all is said and done Bill’s compound interest account made an extra $195.86, almost a third more than the simple interest account! That’s the power of compound interest: when you hire your dollars to work for you those little bastards go all out churning out greater and greater profits each month that snowball into bigger and bigger amounts of money which in turn earn you more and more money. I wasn’t kidding when I said magic dollars are the best employees you could ever have!

Still not convinced about how powerful compound interest is? Let’s take a look at another case study.

Compound Interest and Retirement

We’re going to look at compound interest as it relates to retirement, but first I want to introduce you to three people.

We met Bill in our first example. At 20 years old he stumbled across a great blog on the internet that featured 10 steps to financial success. It wasn’t always easy but he managed to follow the steps and sock away $5,500 into his retirement account each year to prepare for the future. At 40 he suffers a pretty significant professional setback and despite his best efforts he’s unable to save anymore for retirement. At age 65 a medical condition forces him to retire permanently. In total he manages to save $5,500/year for twenty years for retirement.

Cindy is 30 years old. She found the same blog Bill did but ten years after him. She realizes she’s spending too much on some dumb things and cuts her spending without taking a big hit to her quality of life. She also gets her lifestyle creep under control which frees her up to start putting $5,500 into a retirement account each year. She does that consistently for the next 35 years until retiring at age 65.

Lastly we meet George, age 50. George never found the blog that Bill and Cindy did and never bothered saving for retirement. Now that his work end date is kind of in sight he’s decided he’s going to turbo-charge his retirement by putting away $10,000 every year until he reaches age 65. At almost twice the savings rate of Bill and Cindy, George is satisfied knowing he’s doing everything he can to save.

So who winds up with the most money? For our example we’re going to provide each of our three subjects with the same retirement account. They broadly invest in index funds and over the course of their investments they each earn a rate of return of 7% annually each year (quick note: this probably would never happen in the actual stock market, getting exactly 7% on three different accounts investing over different timeframes, but for ease of our example we’re going to assume they all line up into the same periods of growth and the market just keeps churning). How did Bill, Cindy, and George do?

Thanks to the most powerful force in the universe Bill takes the top prize walking away. Not only does he clear the most amount of money in his savings at around $1,500,000 but he also invested the least amount of money to reach that point. Cindy is right behind him with about half as much in savings, and George is taking up the rear with barely double what he put into savings in the first place. He’s going to find it very difficult to retire at 65 with only a quarter million dollars in savings.

Here’s what the growth rate looked like for our three comrades over the 45 years they had to save for retirement.

Because he started the earliest, Bill had the longest to benefit from compounding interest. Even though he could only afford to put money away into his retirement account for 20 years and it was half as much as some of his colleagues could afford to put away he still managed to build the most wealth. That’s because he was hiring magic dollars to work for him the earliest so they in turn had more time to hire more magic dollars, who in turn hired more. By the end of his time period in saving for retirement Bill’s magic dollars had hired more dollars than he had originally invested!

Cindy fared a bit worse but not too bad overall. She saved for 15 years more than Bill but she started saving 10 years later than he did which cost her more in time for allowing her magic dollars to employ more magic dollars. She wound up with a pretty sizable nest egg, but if she had just started reading the Bill Stark Blog a bit sooner she would have had nearly double her ultimate retirement total (or more considering Bill could only afford to contribute his own dollars into his retirement account for the first 20 years!).

Lastly we come to George. Even though George put in nearly double the amount of money into his retirement investments each year as his colleagues Cindy and Bill he wound up with the least amount of money because his magic dollars had the fewest years to hire more magic dollars. In fact, George is likely to need some help in retirement if he can’t keep working past 65 with such a paltry amount in his retirement account.

The moral of the story? Compound interest is the most powerful force in the universe (sorry Einstein!) but your magic dollars gain compounding power the earlier and more of them that you can afford to put away. Doesn’t it make you want to start saving today? And even if you feel you’re in George’s age range, it’s still not too late! George managed to double his money in the fifteen years he saved thanks to those magic dollars. That’s all the more reason for you to start saving now.

When Magic Dollars Turn to the Dark Side

By now you know how powerful magic dollars and compound interest are when they’re working in your favor. But those same dollars can actually be turned against you. How? When you give them to someone else to use in exchange for extra dollars to spend today. I’m talking about debt.

Most consumer debt, including things like student loans, use compound interest to calculate your interest payments. When you take on that debt to spend on something that you want or need today you’re firing your magic dollars from your employment and sending them right across the street to go work for someone else. Those magic dollars? They go right back to compounding but they do so by sapping your future ability to compound dollars in your own favor. You’ve seen how powerfully those dollars can work for you; imagine how powerful they are working against you!

The solution to this problem is fighting back against magic dollars that have turned to the dark side. When you make additional payments against the principal of your debt you’re cutting off someone else’s magic dollars at the knees. You’re eating into the amount that is compounding against you ensuring that next month you owe less and can put more money into the principal of the loan instead of the interest your lender profits off you with. That means that the month after that you’re paying less interest and paying more principal. In fact, there are two different methods you can use to make sure that when you owe money you’re doing everything you can to cut off those magic dollars that are working against you. Read more about those methods here and here.

Compound Early, Compound Long

The crazy thing about the most powerful force in the universe is that anyone can take action to harness it. All you have to do is start saving your money and investing it into an account that will yield compound interest returns over time. The key to making the most of this powerful force is to hire as many magic dollars as you can as early as you can. If the force is working against you in the form of consumer debt you can “hire” those magic dollars away from your debtors by making additional payments each month towards the principal on your loan (there’s a reason, after all, why paying off high interest debt is so high up on the 10 Steps plan).

It doesn’t matter where you’re at in your life or what you’re doing; the more magic dollars you can hire now the greater the power you’ll yield from compound interest and the better off you’ll be financially in the long-term. So get started harnessing this powerful force today.

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