Compounding Interest

In the lesson on how to create a budget, I tried to emphasize the importance of paying yourself first. In this lesson, I want to go more in depth on that topic and show the power of starting a retirement fund as early as possible.

You might be thinking you are too young to worry about retirement. After all, that is still 30 or 40 years away, right? But that is exactly why you should be worrying about it now. By saving money now, you have a major advantage that you won’t have when you get into your 40’s, 50’s and beyond. That advantage is called compounding interest.

What is compounding interest?

As you know, when you deposit money into a savings account, the bank pays you interest on that money. The original amount you put in to the account is called the principle. With normal interest, the bank calculates the interest based on how much principle is in the account. So if you have $100 principle at 1% interest, you get $1 per year in interest. After 50 years you will have received $50 in interest, plus your principle, for a total of $150. Nothing to brag about there. But this is where compounding interest becomes powerful.

Compounding interest means that the bank pays interest not just on the principle, but on all of the interest already earned too. So using the example above, we would start with $100 at 1% interest, and we would still get $1 the first year, and end up with $101. But this is where compounding interest is different. Now, we get interest on the full $101, so in year 2 we get $1.01. After 50 years, we would end up with $164, compared with only $150 if we used normal interest. This may not seem like much, but keep in mind that this is only on $100, at a measly 1% interest. Think about if we started with $1,000, or if we could get something like 10% interest.

As I write this, I am 24 years old. If I can save $5,000 by the time I am 30, then invest it at 10%, I will have $140,000 when I am 65.  But if I wait until age 35, I will only walk away with $87,000. That is a difference of $53,000 I lose just by waiting 5 years. This shows the power of starting a savings program as soon as possible.

Also, remember that this calculator assumes only a starting value. It does not account for money added over time. If you continuously add money over time, the result becomes even greater. So I strongly encourage you to go set up a savings account now, and set up automatic weekly or monthly transfers into the account. Even a small amount is better than nothing. Also, before you open the account, make sure it has compounding interest. Most do these days, but double check before signing anything.

In future lessons, we will talk about how to build your wealth and get those higher interest rates used in some of the examples above. But for now, a simple savings account is a great first step toward a comfortable retirement. The most important thing is to start today.

Summary

Even a low interest account can create great returns over time, but you need to start as soon as possible.

Putting more into savings over time can increase earnings even more.

Pay yourself before any other expenses. Make it automatic so you don’t even think about it.

When opening an account, make sure the interest is compounding interest.