How to Harness the Power of Compounding Interest

Some of you will know what DR stands for, for those who do not know it is Dave Ramsey. Now, I know posting this is a bit crazy… since I know there are many die-hard fans out there. I do not dislike his baby steps but they do not work for me. As I mention in my ‘Introduction’ post, personal finance is personal. I only have one debt, my student loan. I also have it set up on IDR which means that my monthly payment is a huge payment of $0.00. This is because I get paid in a non-US currency, I had it in place before I left the US as well because of my income.

Part of his baby-steps is to have a $1000.00 emergency fund (EF) and once that is funded you throw all your extra money at your debt and do not add additional money into your IRA, 401K, other savings.

However, compounding interest is your greatest friend and worst enemy, adding a little here and there allows your money to work for you. This creates another stream of income and allows you to save for a rainy day. I prefer to have at least 3 months of income saved in cash in a regular savings account. This does not accrue as much interest but it gives me a peace of mind.

In addition, if an employer offers 401K matching it would be almost insane not to take it because it is literally FREE MONEY being added for your retirement.

In DR baby steps there is also no room for creating streams of passive income. I have done some calculations with Excel and even if I followed the Baby Steps to a T, I would only be debt-free a couple months early. That is not enough of a difference to me to lose out on all that compounding interest or income from other sources.

I added the spreadsheet below. Assuming you retire at 60, and you start off with your $1000.00 EF. The ages are for when investing that EF begins into the SP 500. Assuming an annual return of 7%, which is the average when adjusted for inflation. This calculation assumes that the 25 year old is still paying down debt as they invest, the 30 and 35 year old paid off debt first before investing. As you can see the 25 year old is light-years ahead, if they only add $100.00 on a monthly basis. The 30 and 35 year old need to add more than $100.00 to catch up with the 25 year old.

Retiring at 60
Starting Age253035
Present Value100010001000
Interest rate7.00%7.00%7.00%
Term (years)353025
Future Value at 60$191,611.61 $130,113.60 $86,732.59

I do understand why these steps exist and they are wonderful as it is somewhat psychological. It makes debt pay-off a game, and it ensures success. Especially since you see the debts get paid off quickly.

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