If you’re going to learn only one thing about personal finance, let it be the miracle of compound interest. Pretty dramatic right? Yes it is, and for good reason. Quite simply, principal + interest + time equals huge savings over your lifetime.
Most of you are familiar with simple interest on a loan or investment which is the principal amount x the interest x number of days. Compound interest take the concept a step further. I could try and craft a great definition of the term, but I found that Wikipedia already has a definition that’s easy to grasp:
Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously-accumulated interest.
Check out the following quick video for further explanation:
Imagine you’re 20 years old and you’re just starting your first real job. You have expenses like everyone else, but you manage to save $200 a month or $2,400 by the end of the year and you invest it in a portfolio of Exchange Traded Funds (ETF’s) that makes a achievable 8% return. Now do that again every year for the next 40 years until you retire, all the while re-investing your returns, and you could end up with $758,641 depending on when your interest compounds (monthly quarterly, yearly, etc)!
Want to be a millionaire at the end of 40 years? Start saving more than the $2,500.00 a year. As your salary goes up throughout your career, combined with bonuses, and other small saving steps, this shouldn’t be very hard.
Even if you get a late start, you can still catch up. Say you’re 40 and circumstances have caused you to neglect your savings. Start saving $1,500 a month earning 8%, reinvest your gains, and you could have $975,537 by the time you’re 60!
See for Yourself
Want to play around with some numbers and see the power of compound interest for yourself? Try the Reluctant Credit Guy Retirement Savings Calculator to get an idea of how it works.
Do It Now!
Start saving today, to be rich tomorrow! There are some great tools out there which I’ve written about to help kick your savings into high gear. If you have children, teach them the concept and help them execute. The sooner they start, the quicker they can support you in your old age!