Personal Finance

Compound Interest and Saving for Retirement

Albert Einstein said it best, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”  What is compound interest?  Well, it’s really simple, compound interest is interest calculated on the initial principle (the money you deposit) that also earns interest from itself.  For example, if you had a $1,000 in an investment account with a 10% rate of return, after the first year you would have your initial deposit plus $100 ($1,000 *1.10 = $1,100), then the second year you would have $1,210 ($1,100 * 1.10), and third year you would have $1,331 ($1,210 * 1.10 = $1,331) and so on.  You are simply watching your money grow over time due to the power of interest compounding over time.  Now let’s take an example of a retirement account, if you had a $1,000 initial deposit on a retirement account that averages a 5% rate of return, and say you add $60 ($2 per day) a month for 30 years, you will end up with a large portion of money from reinvested earned interest (the power of compounding interest over time).  Let’s leverage the government’s investor.gov compound interest calculator athttps://www.investor.gov/tools/calculators/compound-interest-calculator and input the numbers stated above.  You will notice the total future value or the amount you will have in your retirement account if you reinvested your earnings and never took money out, you would end up with more than $52,000!

int calc

Let’s do some math to learn exactly how much is earned in interest over a 30-year period and what is actually deposited out-of-pocket from the example above.

math

If you look at the table above, you will only deposit $22,600 out-of-pocket and more than double your money with earned interest.  This is related to the rule of 72, which states that if you divide the annual return by 72, it equals how many years it takes to double your money (72 / rate of return = years to double money).  Look at the image below from Investopedia.com.

rule72

With a 5% return it takes 14.4 years to double your money without depositing any monthly amount on top of the initial principle.

int calc 2

Do you see the power of compounding?  This is why it is so critical to start allocating money to your retirement / investment accounts, because the sooner you start the more money you will have when it really matters.

Summary:

  1. Compound interest is your friend, not your enemy!
  2. The earlier you start the better. Start contributing a little and increase your contribution each year.
  3. Reinvest your earnings.
  4. The more you contribute monthly/annually the more money you will have in the long run.
  5. The Rule of 72 equation is: 72 / (Rate of Return) = Years it takes to double your initial deposit.

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