A Lesson in Compound Interest


Compound Interest, Rule of 72, retirement, savings

Making compound interest work for you to save more in the long run

With the high prices of fuel, food, and other living expenses, it’s hard for many of us to think about saving money for the future, such as retirement or a child’s education. However, you might be surprised to learn that even a little savings can go a long way if it has the benefit of time. There’s a very simple factor that makes that possible. It’s called compounding interest.

What is compounding interest?
When interest is compounded, it means you earn interest on interest rather than just earning interest on the principal alone. Interest accrued in prior periods is added to the principal, and then interest in the current period is calculated on the total. Your investment grows exponentially.

So if you invest in a savings vehicle where interest is compounded monthly, such as a CD, and save $100 at a rate of 3%, after the first year you’ll earn interest on $103.

Why it pays to save for retirement early
The premise behind compounding interest is simple: the longer you save, the more time your money has to grow. This gives you a great advantage when it comes to saving for a long-term goal, such as retirement. Donating as little as $2,200 a year starting at age 22 can result in a significant nest egg by the time they reach retirement age. That’s because they will be earning interest on interest, helping to build your savings even faster. An example of the power of compounding interest.

To witness the benefits of how saving early can help you accumulate more, consider these scenarios:

You decide to contribute $2,500 a year to a retirement plan. We’ll assume that you will retire at age 70, and your investments will earn an average return of 7 percent.

• If you start saving at 22 years old, you’d accumulate: $944,997.50
• If you start at 27 years old, you’d accumulate: $662,802.13
• If you start at 32 years old, you’d accumulate: $461,600.73

That means, delaying your savings program for just five years would give you more than $300,000 less at retirement, and more than $500,000 if you waited 10 years to save.

It pays to save early and often. If your employer offers a match and you don’t contribute to your retirement plan, you’re virtually throwing money out the window.

Lastly, don’t forget to factor in taxes
Always factor in taxes as part of your savings goals. If you choose a tax-sheltered account, such as a Roth IRA, you can keep all your account earnings for yourself. Keeping up with inflation is important. In 20 years, $100,000 won’t have the same buying power as it does today, but that should motivate you to start saving as soon as possible.

Take into account that your income will likely grow over the course of your lifetime. If you increase your savings amount with each pay raise, you’ll have more money to compound and to help you accrue a large, golden nest egg for your retirement.

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