Two words: compound interest.
Compound interest is the 8th wonder of the world.
There are two powerful forces that are as essential to finance as gravity is to the universe:
- Compound Interest
The idea of time is straightforward, but compound interest can be confusing to people who are new to the world of finance and money. Understanding compound interest can exponentially increase the amount of money you earn in the bank, and who doesn’t want that? Let me help you wrap your head around how it works so that you can reap the benefits of compound interest and time.
Two Quick Definitions
If you’re really new, here are a few terms to understand. If you know them, then you can skip to the next header.
The principle is how much money you initially throw in the bank. If I go deposit $5,000, then my principle is $5,000.
Interest is how much money you earn from your principle. Interest is always written as a percentage. That percentage is how much more money I get at the end of a certain amount of time from having my principle sit in the bank. For example, if I earn 10% interest per year on my $5,000, then I get another $500 at the end of the year.
So far, we’ve put $5,000 in the bank and earned $500 in interest, because the interest rate is 10% of the $5,000 we put in. Now we have $5,500 in the bank and all we did was drive to the bank a year ago. That sounds great, so what’s the big deal about compound interest?
Compound interest is interest that you earn on your interest. Let’s keep all the same numbers. You put $5,000 in the bank, earn 10% interest, and after a year you have $5,500 in the bank. If you save that money for one more year with a compound interest rate of 10%, you’ll get 10% on your initial $5,000 PLUS 10% on your $500 interest earnings. That’s another $500 from your principle and an extra $50 from your interest.
I can already see the comments saying “That’s it? The 8th wonder of the world is worth 50 bucks?” After one year, yeah, it’s only $50. But after 40 years, you’ll have $226,296.28 without touching your money once.
That means if you’re 25 and you put $5,000 in the bank, you don’t put in a penny more, and that money grows at 10% compound interest, you’ll have $226,296.28 waiting for you in your retirement account at 65.
If you’re 20 and you wait until you’re 65, you’ll have $364,452.42. Compound interest’s real value comes with time.
Compound Interest’s Best Friend: Time
Here’s how we jumped from $5,000 to over $200,000. After one year at 10% interest, you get your $5,500. Another year goes by and you earn another $500 from your principle and $50 on that interest.
One more year goes by, and you not only earn $500 from the 10% on your principle, but you also earn $55 from the 10% of your principle interest and 10% of the $50 in interest you earned the year before. Every year, your interest compounds itself and grows year after year. There’s a great online calculator that does all of this for you. So now you’re probably wondering…
How does this work in real life?
A 10% interest rate is great for calculating easy numbers for an article I’ll spend 90 minutes writing, but a real bank will only give you a compound interest rate between 0.1-1.05% per year. To get the high earnings over time, you have to add money to your account every month. When you do that, both your interest payments and your principle increase. Just adding 10% of your check to your account every month can have a huge impact on your savings in the future.
Let’s say you get the low end of the stick and get a .1% compound interest rate. If you put $5,000 in the bank and put $300 in that account every month for 40 years, You’ll end up with $152,047.85 in the bank just in time for your retirement account to open. Start earlier and wait 45 years, and you’ll have $170,845.65. That’s almost $19,000 more than the other guy who started saving just five years later.
But you don’t have to settle for 0.1-1.05% in a savings or checking account. You can earn a lot more if you start investing. Investing carries more risk (the value could go up or down in any given year) but your returns could be a lot higher. On average, the S&P 500 has returned 7% since its inception in 1928. The S&P 500 is a broad market index that gives you a high level picture of how the stock market is doing.
The next time you think about buying that $70 hoodie, think about what $70 would be worth in 40 years. At 10% annual interest rate, it’s $3,168.
In this article, I assumed that you have a retirement account that you’re putting money into and I made it sound like giving up 10% of your monthly check is easy. I know that neither of those things are true for everyone. What you should take away from this anyway is:
- Small savings over time can make a big impact
- Time is your friend
Young people have one advantage our parents and grandparents don’t have: time. If you start saving early, you will thank yourself when you reach retirement and have that extra cash waiting for you.
- Open a separate savings account and checking account. These accounts are low risk since the interest is pretty much guaranteed. But the interest is low. Even the ones that advertise “high interest” are only high when compared to other savings and checking accounts. Open a separate account anyway. Getting 1% on checking will help your money counteract inflation and gives you a separate bucket of money that you can grow over time (instead of spending it).
- Start investing. Investing carries more risk (since the price of the assets you hold can go up or down) BUT the return and compounding effect could be a lot higher than keeping it in a bank. Here’s an easy and friendly way to start investing with investing for as little as $50.
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