The Eighth Wonder of the Modern World

Personally, I would rank it number one, but then there are those who think I'm too materialistic as it is. But let's face it. Money may not be the most important thing in the world, but it does make life a little easier.

What am I talking about? The Eighth Wonder obviously has something to do with money. Yep. It's central to every financial decision you'll ever make, whether you realize it or not. I'm talking about interest, specifically compound interest.

Interest is what you pay in return to a lender, in addition to the principal, to borrow their money. It can be a little rate, let's say, 2% or a high rate, of 21% or higher. We mostly think of interest when we purchase homes, cars, and get a credit card. That's when we pay out interest.

Interest can also work in our favor. Money markets, savings accounts, bonds, etc, all pay a certain rate of interest to us in return for the bank using our money. We usually pay them more on loans we take out than we ever receive on deposits we make to savings or investment accounts.

The wonder of compound interest is remarkable. I knew it was a wonder, but until I actually crunched some numbers the other evening, I didn't realize just what compounding interest could really mean.

Compounding interest means you deposit money in, say a bank. The bank pays you interest on that money because they use it while it's on deposit. If you leave that money there and never make additional deposits, it will still accrue interest. Let's use $100 and 10% interest. Ten percent is very high and we probably won't see that high an interest rate, but it makes this example easy to prove.

$100 x 10% = $10 interest added to the original $100 = $110.
$110 x 10% = $11 interest added to $110 = $121
$121 x 10% = $12.10 interest added to $121 = $133.10
and so on

In just a couple of deposit cycles you have added $33.10 to your original investment of $100. Take that out over years and you can have a very nice nestegg.

But what happens when you add additional deposits?

$100 x 10% = $10 interest added to the original $100 = $110
$110 + $100 = $210 x 10% = $21 plus $210 = $231
$231 + $100 = $331 x 10% = $33.10 plus $331 = $364.10
and so on

Do you see the difference after just three interest periods? $231.10? This is what I found when I started wondering how having a Private Retirement Account could effect me. I decided to add the extra $100 because I would be adding to the account every pay period.

I began crunching numbers when I began thinking about Private Retirement Accounts going hand in hand with Social Security. I have, at most, 12 years before I retire. I began wondering how much I could have if I put only $100 into an account bearing 3.5% interest (a little high for right now, but that's the figure I chose, so live with it) every two weeks (which is my pay schedule). I don't have the figures in front of me (my computer is in the shop) so I can't give exact time frames and numbers, but after a short period of time (weeks, a couple of months) the interest paid on principal was more than the deposit I would be making. After twelve years of making $100 deposits every two weeks, I would have $580,000 in the account (actually more, but I don't remember the exact numbers).

As I understand Bush's Social Security plan, you would put part of your Social Security payment into a PRA which would pay 3.5% (the amount I heard, but which could change as we all know. It could go up or down as do all interest rates) and would compound monthly. I also understand that the employee could put their full share into this account with the employer's contribution going into the traditional Social Security fund.

So I took the amount I pay into Social Security and started with January 2006. I was able to determine when my pay periods for 2006 through 2016 would be and using a spreadsheet (Excel) used the formula demonstrated above. The only difference was I totaled the deposits for each month and figured the interest on that month and added it to the amount deposited. Then, for the next month, I added that months deposits to the amount from the previous month and added the interest on the total amount for both months. And extrapolated the chart out through eleven years. At the end of the eleventh year, I had more than $700,000.

If I only live to 85 years of age, that would give me $35,000 per year plus it would continue to earn interest every month. I think I could live on that and the pension I will receive. Think of what someone just starting out could have at the end of thirty (or more) years in a private retirement account! I used Excel to do the calculations as I know my math could be off, so I eliminated that problem. Even if my numbers are off, wouldn't it be nice to have money that you have earned go into an account that you can leave to your heirs? With Social Security, you put in hundreds of thousand of dollars and then, when you die, the government keeps it. It's your money! It's money you earned, but the government keeps it! That's legalized theft and it's wrong. A better rate of return on my money is worth the change, but keeping that money is even more important to me.

Here, thanks to my other favorite reader, Doyle, is a link to a Social Security calculator. The numbers are rough, but not too far off.

Private Retirement Accounts? Bring 'em on!