Image Credits stevepb, CC0 1.0
Have you ever wondered how investing small amounts of money is helpful? It seems mind boggling that a simple $50 here and there can add up to a worthy amount to use for retirement. The magic comes from compound interest.
Commonly, we think of interest as a bad thing. Credit cards are known to charge ridiculous amounts of interest. It can make paying down debt extremely difficult. When it comes to investing, we are on the good side of interest. Compound interest is what will grow your savings into a nice nest egg.
What is Compound Interest?
When you put money into your bank or credit union, you generally only receive minimal amounts of interest. This is called simple interest, and it is only on the principal. For example, if you started with $1,000 in the bank, you would earn $20 if the interest rate was 2% per year. The next year, you would receive the same $20. This would continue. After 40 years, you would only gained $1,800. That isn’t enough to retire!
The difference between compound interest and simple interest is that you will earn interest on the interest you have already earned. Back to the $1,000 example, you would still earn $20 that first year. The next year, you would earn $20.40 because you are now earning interest on that extra $20. This will continue, and after 40 years, you would have $2,208.04. It’s a difference of $400.
How Compound Interest Helps Investments
Let’s look at a simple example. If you invest $10,000 today at 6% interest, there will be $10,600 in your account at the end of the year. Instead of removing that extra $600, you must leave this in the account. This is how the magic will happen. After two years at 6%, your account now has $11,236.
Each year, you interest is now earning you even more money. The increase in the amount made every year is beginning to compound. This will continue for as long as you continue to reinvest. If the money in the example above was left alone for 20 years, the account would contain $32,071. You would have earned $22,071 without ever having to invest more.
Letting Compound Interest Help Your Retirement
The absolute key to retiring with compound interest is starting early. Now is the time to invest money. The more time given, the more money you can earn on your interest. People closer to retirement age will not reap as many benefits as a person in their 20s. It is not the quick way to build a nest egg.
Retirement may seem like forever away, but you don’t want to wait until you are 40 years old. This causes panic and for good reason. Saving for retirement sometimes does require a huge lump sum ahead of time, but not always. Here is a smaller example of a smaller invest.
A 25 year old decides to save $300 per month in an individual retirement account (IRA). The account earns 8% annually. This smart person continues to invest $3,600 per year for 40 years. This equals $144,000; it’s a fairly decent amount but surely not enough to last all the years of retirement. Compound interest gain this person an additional $863,212. She now has a total of $1,007,212 in her IRA which is a consider amount.
Having a simple savings account is fine, but it is never going to be enough to retire upon. It is the best route for emergencies and saving for vacations. If you want to retire with peace of mind and the ability to travel or chase dreams, utilizing compound interest is important. The magic is in the math; compound interest is your best friend when you invest money.