You may have heard many people tell you that you need to start saving for retirement or start investing as young and soon as you possibly can. Why is it so important to open an account early? The answer is probably one of the most, if not the most, important concept when it comes to investing.
Compound interest. So what is it, and why do you need to know about it?
What is interest?
Before we break down compound interest, let’s first understand what interest really is. You’ve likely heard the term be thrown around, especially when it comes to loans or debt.
Interest is the price of borrowing money. It is a payment made in exchange for the use of money over a long period of time. So for example, say you take out a student loan for $10,000 at a 2% interest rate. You will receive that $10k, which you plan to pay back, and the cost of taking that loan is 2%. That 2% interest rate is how banks make money for giving loans, otherwise they’d just be lending out tons of money and never getting anything in return. As a result, that $10,000 you took out as a loan actually costs you $10,200, because you have to repay $200 worth of interest.
But, interest can actually work in your favor when investing. If you remember from Part 1, when you invest in a company YOU are the one lending the company money, so in return they repay interest in the form of increasing the value of the stock you hold. This is how you start to earn more and more money when you invest; if the companies you’re investing in are growing, performing well, increasing earnings, etc, the value of your investments will grow and you’ll start earning a higher return.
Compound interest is the secret that really helps your money grow exponentially. Compound interest is basically interest on top of interest. Think of compounding as another word for growing; when something is compounding, it is growing on top of itself. This means that as you invest and earn interest and your balance grows, you’ll start earning interest on top of your money that has already earned interest.
Let’s break it down with an example. Say you invest $100 in Year 1 and earn 7% interest. At the end of the year, you have $107. Let’s assume in Year 2 also earn 7% interest; but now you are earning 7% on $107. This brings the Year 2 total to $114.49. Year 3 follows the same process; earning 7% on the ending balance of $114.49, bringing the ending total to $122.50. Get the picture? Now let’s imagine this process happens over the span of 30 years. At the end of 30 years, you have almost $800, which is far more than the initial $100 you started with.
What makes compound interest powerful?
Compound interest starts to show off when it happens frequently, and over a long period of time. The frequency of compound interest is a huge game changer. In the example above, we looked at annual compound interest, meaning you’re only earning interest once per year. But more often than not, you can earn interest on a monthly, weekly, or even daily basis. This is the engine behind exponential growth; the faster and more frequent your money compounds, the faster it’s going to grow.
Let’s look at another example. Say you are investing for retirement, and you contribute to your employee-sponsored 401k on a monthly basis. Let’s imagine each month you contribute $300 starting with your first job at age 22. That means that your compounding frequency is monthly and you will be contributing over a long period of time, until you retire at 65. By the time you reach retirement, you’ll have over $460,000. If you start 10 years later at age 32? You only have $200,000. If you had just saved $300 per month rather than investing it, you’d only have $118,000.
This shows the power of compound interest, and why starting early and investing often (part 3) is so important. When you’re young, time is on your side. You can take advantage of starting early; look at the difference 10 years makes! It costs you hundreds of thousands of dollars because of compound interest.
If you want to play with numbers, you can check out a compound interest calculator here. These calculators can help you figure out how much money you need to set aside and on what basis in order to reach your long-term goals.
Compound interest will, without a doubt, help your money grow exponentially. Taking advantage of this early on, as soon as you can in your 20’s, will really impact your long-term earnings and wealth. It is very hard to catch up if you put off investing or saving for retirement; you saw in the example that it’s a loss of hundreds of thousands. Prioritizing investing early will set you up for the future, and your future self will thank you for it!