“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.” - Albert Einstein
The definition of compound interest is simple: it’s the interest you earn on both your original money and on the interest you keep accumulating. Compound interest allows your savings to grow faster over time because each time interest is calculated and added to the account, the larger balance results in more interest earned than before.
In a typical savings account interest is compounded daily and paid monthly. A simplistic example is if you had $10,000 in a savings account that earned 1%, you would have earned $100 of interest after 1 year bringing your savings account balance to $10,100. In the second year, you would earn 1% on the $10,100 ($10,000 initial balance plus $100 interest), increasing your balance to $10,201. While compound interest is easiest explained using interest earned on savings, it also applies to investing.
Compounding Investment Returns
Saving for retirement involves more than putting money in a savings account; the most effective way to grow your wealth over the long-term is by investing in a diversified portfolio of stocks and bonds. When you invest in the stock and bond markets, you don’t earn a set rate of return, rather you earn a return based on the change in value of your investments. When the value of your investments increases, you earn a positive return. If you keep your money and the returns you earn invested in the market, those returns are compounded over time in a similar fashion to the way interest is compounded.
For example, if you invested $10,000 in a diversified portfolio and that portfolio gained 5% in the first year, you would have gained $500 and your portfolio would be worth $10,500. If the portfolio gained 5% in the following year, your portfolio would then be worth $11,025. Keeping the example going, if you invested the $10,000 in a diversified portfolio for 30 years and earned an average of 5% annually, your portfolio would grow to be worth more than $43,000.
Compounding Additional Contributions
The power of compounding is apparent just by looking at the growth of a one-time deposit, but the key driver for long-term wealth creation is steady contributions to savings buckets. Those savings buckets could be a 401(k), Individual Retirement Account, brokerage account or emergency fund, which all benefit from compounding of the original deposit plus any subsequent contributions.
Say you were to start a lifelong practice of deferring 10% of your salary into your company’s 401(k) when you begin your first job. Assuming that your initial salary is $50,000, your salary will grow at an average annual rate of 4% and your 401(k) is invested in a diversified portfolio that will earn 5% annually, you would have roughly $1,000,000 after 40 years. If you continue saving for another 10 years, the balance jumps to over $1,800,000!
While a time period of 40 or 50 years may seem over-the-top, for a young professional this is a realistic time frame given an average retirement age of 65. The enormous difference between the amounts accumulated over 40 and 50 years demonstrates the reality of compound interest: the most important thing you can do is to start saving early.
The Earlier You Start, the Bigger the Benefit
Young professionals have a great advantage in comparison to older investors, because they have time on their side. Time is your biggest ally when it comes to saving for retirement or any other financial goal. The sooner you begin saving, the sooner compound interest can start magnifying your results. It’s easy to get discouraged after a short time frame because a few years is too short to see a significant benefit from compounding.
Consider two different savers, one starts at age 25 and the other starts at age 35. In order to retire a millionaire at age 65, the 25 year old will need to save about $655 a month, assuming a 5% return. In comparison, the 35 year old will need to save about $1,200 a month just to hit the same goal of $1 million at retirement.
Use Time to Your Advantage
It’s easy to get caught up in targeting a specific number or percentage of your salary to save on a monthly or annual basis. The important thing to remember is – when you start saving is just as important as how much you save. Keep three things in mind as you start to save:
1. Start early
2. Save consistently
3. Stick to your investment plan
Working to establish goals, building a budget and developing a savings plan to help you reach those goals are at the forefront of what we do. Please reach out to the team at Upswing Advisor to learn more about the power of compound interest or to jump-start your savings plan to take advantage of your biggest asset: time.