Compound interest sounds pretty fancy. In the world of financial planning, we often talk about how earning interest on your money – either through a high-yield savings account, or through investing – can be a game changer as you try to grow your wealth. Even though compound interest might seem complicated, or unattainable, the truth is that it’s a benefit that anyone can take advantage of if you start saving now.
How Does Compound Interest Work?
Compound interest is actually more straightforward than most people realize. The best analogy I’ve heard goes like this:
Picture you’re standing at the top of a hill, and you’ve just made a snowball. The snowball is pretty small at first. In fact, it might not even make an impact when you go to throw it at your husband (sorry, Brian!). But what would happen if you took that snowball, and started rolling it down the hill?
With every revolution, the snowball would pick up more snow. The bigger the snowball gets, the more snow it can pick up, and the faster it grows in size. By the time it hits the bottom of the hill, you’ve got a good-sized snowball, even though what you started with was tiny!
Compound interest works this same way. You start with a small investment early on in your career. As the principal investment starts earning interest, it’s able to continue earning more and more interest over time. Basically, you earn interest on your money. Then the interest you earn also earns interest.
By the time you reach retirement, your once-small retirement savings account will have grown significantly. Compound interest is a fantastic way to start working your wealth, and taking advantage of the benefits of saving early – even if you can’t afford to save very much when you’re first getting started.
That being said, compound interest isn’t a one-and-done thing. You can’t put $10,000 in your retirement account one time and expect compound interest to do the rest of the work. Let’s go back to the snowball example for a second. Can you imagine how much bigger your snowball would be if, every few yards down the hill, you stopped and manually packed more snow onto it before sending the snowball on it’s way again? Your snowball would grow so much faster!
The same is true for your retirement savings. Your initial investment, or contribution to your retirement savings account, will grow. Compound interest will work to your advantage. But you’ll be able to grow your nest egg more quickly, and stay on track to reach your retirement goals, if you contribute early and often in your career.
Compound Interest in Action
Imagine our friend Early Eleanor starts saving for retirement at age 25. She invests $100 a month for 10 years, and stops investing at age 35. By age 35, she’s contributed $12,000 to her retirement savings account. Earning an interest rate of 6%, her balance would be $15,996.04 when she stops investing at age 35.
Assuming that her annual return rate continues to be 6%, Early Eleanor would have $91,973.11 by age 65 for retirement.
Now, imagine Early Eleanor hadn’t stopped contributing to her retirement savings account at age 35. Let’s pretend that she kept right on contributing $100 each month for 20 years instead of 10. At age 45, Eleanor would have contributed $24,000. Earning 6% interest, her account balance at age 45 would be $44,463.42.
If the account went untouched, and continued to earn 6% interest, until she retired at age 65, Early Eleanor would have a nest egg of $142,600.21.
Early Eleanor is close friends with Late Lauren. Late Lauren waited till she was 35 to start investing. After talking to Early Eleanor about her investing strategy, Late Lauren decided to contribute $100 each month to her retirement savings account, earning a return of 6%. She contributed for 10 years, until she was 45 years old.
Even though she earned the same interest rate as Eleanor did, Late Lauren’s account would only be worth $56,301.47 at age 65 when she’s ready to retire.
Even if Late Lauren decides to contribute $100 each month at an interest rate of 6% over 20 years, her account will only be worth $79,627.21 when she retires at 65.
|Case||Saver||Age||No. of Years Contributing $100/Month||Total Amount Saved (with Interest)||Years to Compound (without Additional Contributions)||Balance at Age 65||Money Earned From Interest|
Early Eleanor saved the exact same amount as Late Lauren – but her savings earned so much more, because she was able to take advantage of compound interest. Her money earned interest, and her interest earned interest, over several decades. She gave her wealth more time to compound and grow, and was better set up for retirement as a result.
The Takeaway: You can contribute less money earlier in your career, and still end up with more in the bank when you retire. The longer you give your money to take advantage of compound interest, the bigger your nest egg will grow.
What If I Haven’t Started Saving Yet?
You might be thinking:
Okay, I get it. Compound interest rocks if you’re trying to save for retirement, and can start saving early. But I’m already 35 – am I destined to be a Late Lauren?
Of course, if you could have started saving for retirement earlier in your career, you’d have had longer to take advantage of compound interest and grow your savings. But guess what? Life doesn’t always work out that way.
As a financial planner, I’m a big believer in the fact that kicking yourself for your financial mistakes doesn’t get you anywhere. Dwelling on how you could have been more intentional about saving doesn’t help you right now. So, if you’re creeping up on retirement without having saved intentionally yet, don’t beat yourself up. Instead, put together a plan for how much you’ll need when you retire, and start saving consistently toward that goal. Don’t wait – start now! You still have time to take advantage of compound interest!
Other Benefits of Saving Early
Compound interest is, without a doubt, a magical tool for savings. Earning interest, and having your interest earn interest, is one of the best ways to start working your wealth and growing your net worth. Compound interest sets you and your family up for future financial success. However, compound interest isn’t the only benefit of saving early (and often).
Did you know that if you’re willing to start saving now, you’ll give yourself more time to recover if the market dips? Investing isn’t a foolproof sport. Even if you have a strategy that seems airtight, nobody can predict how the market will behave in a given year. If you start investing early in your career, you’re building in a buffer for yourself. You’ll have more time to grow your nest egg, and more time to recover after the fact if your investments spend a period of time underperforming based on your original expectations.
Saving for retirement, or other big goals, can be tough. Putting together a strategy that works for your unique financial situation takes time, and sticking with it can be hard. This is where working with a financial planner can make a big difference. If you’re worried about your retirement savings, or are ready to get started saving to take advantage of compound interest and work your wealth, schedule a call. I’d love to talk to you about how a fee-only planner can help.