I am trying to use a retirement savings/investment calculator using this: https://www.getsmarteraboutmoney.ca/calculators/compound-interest-calculator/

I chose initial investment of $1500, monthly contribution of $1500, time period = 30 years, interest rate = 5%. Now, the plan is to invest the money in an index fund that on average earns 5% and all dividends are reinvested. I believe 5% is very reasonable on S&P 500. What I have trouble with: What value should I choose for Interest is compounded? Should it be Yearly? When i choose 'Yearly', it tells me that after 30 years, I will have 1.2 million and 688k of that will be interest. This number seems quite high, is it correct?

  • 1
    I may answer properly over the weekend if i get time but 1500 * 12 (months) * 30 (years) is 540000 so it doesn't sound outlandish. You may want to think of "interest" as actually being "capital gains" for stocks with the associated risk. i.e. this is an average amount of return. – MD-Tech Jul 19 '19 at 15:18
  • also remember that you have to reinvest dividends and any crystallised capital gains to get that rate of return. – MD-Tech Jul 19 '19 at 15:19
  • That seems accurate, besides it not taxing dividends (I'm guessing for you it would be a 10% tax on the ~2% dividend yield) but that is variable depending on the country and your tax bracket. That is the power of compound interest. If you really wanted to, you could create or download a spreadsheet to track it growing month by month – rhavelka Jul 19 '19 at 19:15

the plan is to invest the money in an index fund that on average earns 5% and all dividends are reinvested. I believe 5% is very reasonable on S&P 500.

Yes, 5% is a conservative estimate for the S&P 500.

What value should I choose for Interest is compounded? Should it be Yearly?

For the kind of rough hypothetical that is this exercise, Yearly compounding is Good Enough.

This number seems quite high, is it correct?

This is the magic of compounding, which is why investing a little early is so much more important than investing a lot but later.

  • "the magic of compounding" exactly ! add 10 years you only need to contribute half the amount to equal the total amount (not exactly but it's close enough). – xyious Jul 19 '19 at 19:31

One of the great things about these calculators you can play with the values and see the changes in the outcome. So to answer your own question what are the value changes when one does monthly, or daily? There will be a large-ish difference between monthly and yearly but the difference in the amount will diminish as the compounding period shortens. The difference is 25,543 when going to monthly from yearly.

I will ask you to do this. Instead of 30 years, do 31. What is the difference now? About 62K. So you can increase your interest earned by 9% for just working one more year. This is very illustrative about compounding investing. Get started early for what you can. Invest early and often!

Now flipping this on its head, lets say a person decides to have a car payment every year for 30 years. Lets say that car payment is 600 which is about the average now, and it ignores what it will increase to in the future. What does that amount come out to? You will pay 500K with over 283K paid as interest. That is a lot of money. Now you know why banks are so willing to loan you money to buy a car, and why you should only pay cash for a car.

  • The last paragraph is backwards. If you have cash lying around instead of having it invested you miss gains you would have otherwise had. Keep the money invested and get a loan for the car, you'll come out ahead. – xyious Jul 19 '19 at 19:32
  • @xyious: You're correct that "only buy a car you have cash for" and "buy the car with cash" are two different things. Whether to use the cash or take the loan needs a proper analysis though, which not only considers compounding of both loan and savings, but also the increased cost of insurance that the lender requires. – Ben Voigt Jul 19 '19 at 19:35
  • The last paragraph is not a convincing argument against financing cars. The scary $500k figure has to be compared to the total future growth value of the entire purchase price of each car paid up front (the purchase price compounds longer because it is paid before the alternative loan payments are). All of this reduces to comparing the after-tax loan interest rate to the after-tax investment interest rate. If those $600/month payments are computed from a loan rate less than 5%, then the corresponding cash purchases will compound at 5% to more than $500k. – nanoman Jul 21 '19 at 15:48

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