Don’t let money sit around, but focus more on saving in the early days
There are a few key take-aways from this note:
- money sat around doing nothing (i.e. sat in your current account) is a bad idea
- that’s because of the life-changing magic of compounding; i.e. exponential growth
- however, in the early days, just getting money saved is the most important thing you can focus on
- if you’re aiming to retire early, accept you’ll miss out on the biggest benefits of compounding
Part 1: compound interest 101
What actually is compound interest, and why is it important?
We use the word ‘interest’ loosely
When we talk about interest we usually mean two things:
- The cost of borrowing. he amount of money a bank pays you for the privilege of using the money you’ve deposited with them. Typically they’ll lend this out to people (mortgages, overdrafts, etc) and give you a cut of the interest they charge on that.
- The profit you receive as a shareholder in a business. This can either be a dividend which is a share of the profit that business has made, or the relative rise in the share price when you come to sell.
There are two main types of interest
Interest takes two forms,
simple. Compound interest pays interest this year on both the amount you’ve saved AND the interest you’ve earned last year. Remember - compound = interest on interest. Whereas simple interest only pays interest on the amount you’ve saved, and not the interest from last year - so simple = no interest on interest.
Get a free £70k with compound interest
Both are better than no interest, but compound interest is significantly better. This chart shows why.
It looks at someone saving £3,600/year - or £300/month - for 30 years, and shows the difference after thirty years with no interest, simple interest and compound interest. I’ve assumed you’ll get 3.5% interest.
If you benefit from compound interest you’ll have earned over £70k in free money, or a 70% boost to your savings.
Get even more if you can boost your interest rate
To illustrate the effects of compounding, here’s a table that shows for any starting balance, with no ongoing investment, how much your money will multiply by after different time periods, depending on the interest rate you get.
For example, if you put an amount of money away for 15 years at 5%, you’ll double your money.
Part 2: compound interest and FI
What does compound interest mean for financial independence?
Optimise savings first, rates second
You can’t earn any interest on £0.
So, in the early days of your FIRE journey, it makes sense to spend more of your energy trying to optimise your ability to put away savings each month.
That’s not to say you shouldn’t look to get a return on the money, but you shouldn’t be worrying too much about optimising your asset allocation to push the interest rate from 3.5% to 3.7% if you’re only saving 60% of what you could be, for example.
However, as the gap closes, it becomes more worthwhile.
After 10 years, saving £9k/year at 5% only puts you £4k behind if you were saving £10k/year at 3.5%, despite you having saved a whole £10k less. That means the interest rate has given you a free £6k.
This says you’ll always be better off saving more. Although once you’ve got that down, of course it’s still sensible to see if you can push your interest rate higher.
You’ll probably miss out on the best days
What this chart shows is the split of your portfolio that’s the actual money you’ve saved, vs the interest you’ve earned on those savings. It assumes you’re saving £10k/year at 5%.
After 10 years, 20% of your portfolio has come from interest. After 40 years over 2/3rds (67%) of your portfolio is the interest you’ve earned on your savings. That means you’ve tripled your money.
Sadly, if you’re planning to retire early and start drawing down from this portfolio after, say, 15 years, you’ll be missing out on the true life-changing magic of compounding.
It’s worth bearing in mind, but if you’re able to retire after 15 years with everything you need for a fulfilling life, who really cares about the interest you’ve missed out on?