Here's a simple and easy way to change your financial future for the better. We call it - The Miracle Of Compound Interest.
Rumor has it that Albert Einstein really did say the above sentence. Whether he did or not, this simple mathematical process involving money is a truly powerful force. Over time it can make a big difference in your life (and if you have children, a bigger difference in their lives). Some things in life are important and some are unimportant. Compound interest is important.
Making use of compound interest is as simple as saving some money on a regular basis, investing it, letting it make you a return on your investment and then having the interest earn you still more interest. The accumulation over time can astound you. It's one of the major keys to your financial independence.
Let's break it down like this: Compound interest is a way to make your money work for you. That's a key - letting your money make you money instead of you doing all the work to earn money.
To illustrate all this, we're going to define some terms. The first term is "principal" – this is the amount of money you put into the bank to have it accrue interest. It's the money you've saved to invest. The second term is interest – it's the amount of additional money your principle earns you. Interest is expressed as a percentage.
So, let's say you put 100 dollars in the bank at 5% interest, at the end of a year, you'd have 100 times 1.05% or 105 dollars. Your money earned you money. You didn't do anything extra after you deposited your money. After two years, that initial 100 dollar investment would be multiplied by 1.05% twice, and would net 110.25 dollars, as the money gained in interest in the first year would be added to the principle for the second year. Then the money gained from interest earning interest itself, adds to the principle. This is compound interest... interest earning you interest. It may not look like much at first, but over time, it really adds up. And think what would happen if every month, or six months, or year, you added more principle to your savings which, in turn, earns additional interest on top of the interest you've already earned. This arrangement can change your financial future fairly quickly.
How quickly? Well, that depends on the interest rate. There's a rule of thumb called the Rule of 72, which tells you how many years your initial investment will take to double using compound interest. To use it, take 72, and divide it by the percentage points of your interest rate. For example, at 5%, your initial investment money will double at 72 divided by 5, or 14.4 years. If the interest rate is 10%, your initial investment will double by compound interest in 7.2 years. This has to do with your original investment. Think what would happen if you add additional money, on a regular basis, to your initial investment! When you do that, everything happens even faster. Reread Albert Einstein's quote above.
Interest is paid at a pro-rated share on whatever the average monthly balance of the account is, so if you put in a dollar a day, your average balance for a typical month will be $15 for the first month, $45 for the second month, $75 for the third, and so on. Let's look at this case in particular; assume you're 17 or 18, and you'll be looking to retire at age 63 – so you'll have 45 years for compound interest to work it's magic.
Now, most people will spend a buck a day on things like soda pop or snacks without thinking about it. That comes out to $30 per month. Using the interest rate calculator at , putting 30 bucks a month into a money market account pulling 5% a year, and doing that every month, regular as clockwork with no breaks on it, by the time you're 63, you'll have $60,793 saved up.
Now, 5% average interest rate isn't bad, but we can do better. Long term holding of stock market index funds (which are worth an article of their own) has averaged about 10% per year (with some up years, and some down years). Plugging in 8% (for a low return index fund) and 10% (for an above average index fund) for comparative interest rates gives us $158,237 for the medium rate of return, and $314,475 for the high rate of return. If you keep the saving habit going for a little while longer (to age 65, instead of 63), the numbers change to $67,900, $186,300 and $384,575.
The above is based on saving... snack money! What if you get serious and saved even more. The numbers can grow in such a way you become financially independent.
Now, the example we're giving, while nominally for a "retirement" package, isn't actually the best way to go about retirement. It keeps your funds pretty liquid, meaning you can cash out to make the down payment on a house, or on a car. If you're serious about retirement income there's an even better trick, and while retirement seems like a long way off, it's worth doing now, rather than later, because of how compound interest works.
To maximize your retirement, the tool you want is called a 401(k) program, and it may be offered by your employer. (Even if it isn't, you can make contributions to a comparatively similar tool called a Roth Independent Retirement Account, or IRA). The beauty of a 401(k) program lies in two areas – employer matching, and taxes savings.
Up to a certain percentage of your paycheck (for some companies as much as 15%), for every dollar you put in, your employer puts in a matching dollar amount. if you leave your employer before the vesting period (typically 5 years), they get the matching contributions back; after that the money is yours. What this means is that you're getting a head start on that investment doubling since it starts doubling right out of the gate. This is comparable to adding 12 years to the time your money accrues interest.
The other major benefit is taxes. First, your 401(k) contribution doesn't count as income in the year you earned it. At typical tax rates, for every dollar you contribute to your 401(k), you'll only lose 75 cents on your take home pay (75 cents because you would have given the IRS part of your earnings). Compare this with the dollar you would have put in every day for the examples above, and you'll see the immediate benefit.
If you want to keep the money in your pocket the same, every $1.33 you put into a 401(k) reduces your paycheck by about $1 (because of the tax benefits)… and remember, in a 401(k) what you contribute is often matched by your employer. So, for every dollar you don't have to spend on soda, put into a 401(k), you're getting around $2.50 set aside for compound interest accumulation.
The other benefit of your 401(k) contribution is that any interest it earns is tax deferred. It doesn't count as interest until you cash out the account on retirement. In effect, what this means is that your interest rate is increased by a hidden 33%, since that money that would otherwise go to the IRS is now being added to your principal for accumulation.
So, plugging those factors in to our example interest rates, the monthly contribution goes from $30 to $75 ($30 times $2.50), and the interest rate is effectively set at 6.67, 10.65 and 13.33%. Which gives us final end of term investments of $293,986, $1,220,532 and $3,423,368…all for a dollar a day.
So why not start today? Putting the power of compound interest to work for you can make a big difference in how your life works out..