Problem #40: Does compounding interest matter when I start saving for retirement, or is the amount I save more important?
If you don’t have any savings for retirement or otherwise, you have a PROBLEM. Hopefully, by the time you’re finished with this article, you’ll be encouraged to start saving immediately. Compounding interest and time are powerful money-making tools that you can’t ignore.
A wise father was discussing money with his son one morning. The father posed this question to his son.
“Would you like to have $25,000 given to you each day for thirty days? Or, would you rather start with 1 cent and have a 100% rate of return accrued each day for 30 days?”
“Wait, what?” The young man asked incredulously.
“Let me get this straight. You’re asking me if I would rather have $25k each day for 30 days or a you’ll give me a penny and let it accrue 100% interest for 30 days? That’s easy. I’ll take the $25k. That’ll be . . . $750,000.00 at the end. Sounds like a pretty sweet deal!”
The father replied with a twinkle in his eye, “You have chosen . . . poorly. (Indiana Jones reference intended – without the consequences)
You see, you will have $750,000.00 – it’s true. But had you chosen the penny with 100% interest, you would finish with $10,737,418.23!!”
The young man’s mouth gaped open, “10 million dollars? How is that possible?” He whispered.
Compounding interest makes yesterday’s money tomorrow’s fortune. Click To Tweet
You see, your 25k each day was simply adding to the previous days total. Think of this like income from a job. Each week you get a paycheck for the same amount – until you get a raise or a promotion. But once you received your paycheck, the money stopped working for you. It’s like just keeping it in a box under your bed. It slowly adds up over time, but that’s all that’s happening – it’s adding.
But with the penny and the 100% interest, it continued to work for me each day for the entire time. All the money I had continued to generate more money. Think of this as saving or investing. Initially it starts out small, but because all the money is generating interest, it starts to quickly build up. This is described in mathematical terms not as linear (a straight line – or adding), but as exponential. More on this below.
Now, there is no investment on earth, that I know of, where you can get 100% rate of return on your money. If you know of such an investment, you should be writing this article instead of me. But the principle is the same – no matter what your rate of return is. Your money will continue to earn more money, which is called interest. And this interest plus your money will earn even more interest. I’m sure most of you know this, but this concept is called simple compounding interest.
How can you use Compounding Interest to your Advantage?
By investing and saving as much of your money as you can as soon as possible. Most Americans don’t have enough savings. They live paycheck to paycheck (see this story at CBS News). Any savings that you can muster can help to break this cycle.
Let’s explore the compounding interest equation. There are three components of this equation. And you will want to maximize all of them to make the most of compounding interest.
Rate of return (Interest rate)
This is the rate that your interest accrues (accumulates). Different types of investments will yield different interest rates depending on the risk involved. For example, a savings account will yield around 1 % per year. You can probably do better by investing in the stock market (dividend stocks, mutual funds, etc.), but it is more risky. Don’t forget about risk – usually the higher the risk, the higher the reward. In this case, by investing in the stock market, you’ll get a higher rate of return.
For retirement, you will want something that yields a better rate of return than a savings account. Investing in mutual funds inside a retirement account will usually do much better than 1%. But you have to give it time.
Check out the chart below which illustrates how the interest rate affects your savings. This chart assumes you save $500 per month for 25 years.
This is the amount of time your savings/investments have to compound interest. The longer the better. Don’t wait! Start NOW. You can’t afford to put it off.
If you are investing or saving for retirement, and the longer you have to save, the easier it will be to ride out the ups and downs of market. Don’t get nervous when the market goes down, keep saving. Remember, time is on your side.
Check out the chart below which illustrates how time affects your savings. This chart assumes you save $500 per month and get a 7% interest rate.
This is the amount of money that you actually save or invest. This may be obvious, but if you don’t save any money – you won’t earn any interest. The more you save, the more you earn. Don’t complicate it!
Check out the chart below which illustrates how the amount you save affects your savings. This chart assumes a 7% interest rate for 25 years. Notice that the graph is a straight line. This means that the amount you save is not as important as the other two factors. What is important is that you actually save, Save, SAVE, regularly. Learn to live below your means so you can set aside something each month.
Related: A budget is plan for saving.
It turns out that time is the biggest factor in how much money your money will earn. Yes, the interest rate matters, but it doesn’t affect the result as much as time. As we discussed, the amount you save also doesn’t matter that much either. The point is: Start saving – something, anything!! The sooner you start, the more time you have for your interest to earn more interest.
If you don’t have any savings, at least start an emergency fund today. Go, right now, and put $100 in an online savings account. I use Ally Bank. It’s a good start, and that’s better than doing nothing. I also fund a retirement account through my employer. It’s not as much as I would like, but it’s a whole lot better than nothing.
Do you have a regular savings plan for retirement or other financial goals? Tell me about it in the comments below.
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