Compound interest is something we’ve all heard about, and understand at some level, but probably don’t put much thought into.
That’s probably because investing sounds like such a boring topic.
But it’s not when it’s framed as turning $5,000 into one million dollars, is it?
It’s a mistake to ignore how powerful compound interest is, and how much it can help us save for retirement.
So if you’ve only ever understood compound interest at the surface level (as in, your money grows over time), then you’re in for a treat.
There’s so much more behind compound interest that you should understand, and these examples will amplify that.
The Numbers Behind Compound Interest
I don’t think it’s enough to simply say that compound interest can multiply your wealth by a lot.
The classic definition is: interest paid both on the original amount of money and on the interest it has already earned.
That really doesn’t do it justice. It’s something that you need to see broken down. So let’s do that.
(If you want to follow along or use your own numbers, just search for a “monthly compound interest calculator”.)
Let’s say you start with $5,000, that your earnings grow at 6%, that you have 40 years until you retire, and that you’re contributing $100 each month.
At the end of those 40 years, you’ll have an ending balance of $254,932.09. You’ll have contributed $53,000 of that – $201,932.09 came from interest.
Those numbers tell a nice story: you don’t have to actually save [insert-intimidating-amount-of-money] that you think you need for retirement. You just need to grow it.
But I Need More Than That to Retire!
Of course, while $250k is nothing to scoff at, it’s not going to be enough to fund your retirement. It makes sense that you’ll be able to contribute more and more as you grow in your job and earn more money.
So let’s change that scenario slightly. You have a $10,000 balance, growing at 6%, with 35 years left, and you’re now contributing $500 every month.
At the end of those 35 years, you’ll have $797,152.44 saved up. $220,000 of that was a direct contribution, while $577,152.44 was due to growth.
That’s almost $800,000, and a $500 monthly contribution isn’t totally out of the question for those in their 30s who are taking steps to manage their money well. That’s also not counting any bonuses or raises you might get.
Getting to a million isn’t that hard if you can afford to save $500 now.
Let’s go back to the beginning balance of $5,000. If you contribute $500 over 40 years with a 6% return, you’ll end up with $1,055,511.36.
The key is, you need to start now.
What Happens When You Start Later
This is the other side of the coin, and it’s just as important to witness if you think you can put off saving for your future.
Let’s say you’re 40, and hoping to retire at 60. You’ve got 20 years to grow your investments, and you’re starting at the same $5,000 balance, contributing the same $500, with a 6% return.
When you’re 60, you’ll have a whopping $248,726.57. Can anyone say ouch?
Your time horizon was cut in half from the previous example – 40 years to 20 years – yet, your balance decreased by $806,784.79.
Even if you increased your monthly contributions to $1,000, you’d still end up with $480,902.12.
The truth hurts! I hope it’s clear now that starting earlier is absolutely way better than starting later.
Why Compound Interest is Important to Take Advantage of
There’s another factor at play that many people aren’t aware of. There’s this nasty thing called inflation that basically erodes purchasing power over time.
You know how your parents love to go on about how gas was so much cheaper back in their day, and how a pack of gum cost a quarter?
That’s inflation at work. The cost of goods and services rises, and consequently, your money is worth less.
$1,000 today will not be worth $1,000 ten years from now. Plain and simple.
You need to plan for that when it comes to retirement and saving in general. That’s why I’ve said throughout many posts here that you can’t just put your money in a savings account and expect it to grow. It’s not an effective strategy.
Taking advantage of compound interest, however, is an effective strategy, as you saw above. Sure, you still need to save for retirement, but compound interest makes that task a lot less daunting.
As long as you stay in it for the long haul and continue to educate yourself, you should be able to earn returns that beat inflation. (Of course, that’s not a guarantee.)
Just keep in mind that inflation directly cuts into your earnings, so if you’re expecting a 6% return and inflation rises at 2%, your actual return will be closer to 4%.
One More Thing…
As if inflation weren’t enough, you also need to contend with fees when saving for retirement.
If you’re taking the simple road and investing in index funds, then you might not have to deal with a damaging fee structure.
However, if you hire a financial advisor to help you, then you should make sure you go with a fee-only advisor. Those who get paid via commission have incentive to sell you whatever will put the most money in their pocket.
That could potentially mean being invested in fee-ridden funds. Your portfolio can easily lose a lot of its value to fees alone, once everything is said and done.
That’s why getting started early pays off. If you think the odds are stacked against you now, imagine having to battle all of these things with a shorter time horizon. You saw what a crazy difference 20 years made. Most people can’t afford to make that mistake when they’re 10-20 years away from retiring.
I’m Convinced – What Should I Do?
Now that you know you should be taking advantage of compound interest (while trying to beat the rate of inflation), what should your next move be?
If you haven’t started saving for retirement yet, then you should definitely get on that! The two best ways to do that for young adults is to take advantage of your 401(k) at work, and if you don’t have access to one, open an IRA.
You can contribute more toward a 401(k), but saving anything will greatly help you at this point. You already saw what waiting can do to your end result, so the important thing is to take action.
You should also educate yourself about the basics of investing. I know it can be scary to start, but lack of knowledge isn’t an excuse. There are so many resources available to you, so start learning step by step.
If the one thing you’re stuck on is paying off debt or investing for retirement, run some numbers. When you have low-interest debt, it can sometimes be more beneficial to invest as you’ll realize a higher return.
Compound interest is key when saving enough for retirement, but you can only take full advantage of it when you’re younger. Unfortunately, those golden years are barely a blip on any millennial’s radar.
While you might feel like it’s useless to contribute to something you can’t access for another few decades, you’ll be thankful when you’re 50 or 60 and have a comfortable nest egg to retire on!
Were you aware of how powerful compound interest is? Do you think saving earlier is better? How did you get started investing?