At first glance, “compound interest” may come across as an insider buzzword, but financial terms aren’t known for their first impressions — and in this case, it’s the closest many of us will ever get to the idea of “free money.”
If money is associated with freedom, then compound interest is one of the most useful — and relatively low-effort — tools out there to help people take control of their lives and reach their goals. The gist: You sock away a little money at a time, starting early, and automatically invest it — as well as any additional money it generates — in low-risk funds that follow the market. Historically, the market goes up, which means that over the years, your money should grow exponentially.
“Compounding happens when earnings on your savings are reinvested to generate their own earnings,” says Kate Ryan, a director of investment solutions at TIAA. “Those, in turn, are reinvested to generate their own earnings and so on. So over time, compounding can add a lot of value because you have more time periods — more earnings — and those earnings are ‘earning earnings.’”
The strategy is simple: Sock away the money, leave it be, trust in the market’s historical upward trend and let compound interest do its work. “The results are incredible,” says Galit Ben-Joseph, a financial advisor for J.P. Morgan Securities. “This is how wealth is built.”
Why it’s a good idea to start now
In a way, the way compound interest works is similar to how a successful person worked hard to be good at what they do, says Eugenie George, author of Our Money Stories: A Six Week No B.S. Financial Wellness Plan. For instance, celebrity chefs don’t typically turn into industry heavyweights overnight — before being in the public eye, they train for years to make a name for themselves.
“This is kind of like compounding,” says George. “The end goal is [that] you won’t have to stress about it.” Putting in the effort to get started now can set you up for big success later on.
If you’ve been waiting to save until you check other financial to-dos off of your list — like debt or student loans — take a close look at your budget to try to find a few dollars here and there to sock away. Every little bit helps in the long run. For one compound interest example, if a 25-year-old started investing $200 per month (assuming a 6% return), by the time they turned 65, they’d have a nest egg worth $393,700, says Ben-Joseph. But if they’d waited until 35 to start saving $200 a month, even with the same rate of return, they’d end up with almost half that — $201,100 — by age 65.
Now is as good a time as any to sit down with your budget and figure out how to start (or boost) your retirement savings. Investor.gov has a calculator that allows you to test out different saving scenarios that work for your financial situation.
Another perk of getting started sooner rather than later: It can be smart to invest during a market correction (like the one we’re seeing now) since “it makes the compounding more effective,” says Ryan. “They’re able to buy more shares when they’re [priced] lower. So when the price goes up, it compounds even more.”
Check out these two compound interest examples to see how it works in real life.
One compound interest example from Ryan: Let’s say Sarah, age 20, invested $1,000 today. If she didn’t touch it until she retired at age 70, her money could increase by 32 times — meaning she could end up with around $32,000. (This assumes a 7.2 percent growth rate, which Ryan says is reasonable “based on the historical, long-term returns of U.S. large-cap stocks.”)
But what if Sarah waited another 10 years — until she was 30 years old — to invest that $1,000 and leave it be until retirement? In that case, she’d only end up with half as much as above — just $16,000. And if she waited until 40? That’d cut the amount she’d be left with in half again: around $8,000.
The real kicker — or “where it gets really magical,” says Ryan — is that if Sarah were to invest that $1,000 at age 20 and contribute $83 a month (around $1,000 a year) until retirement, then by age 70, she’d have $465,000.
If she did the same but waited to start until 30, she’d end up with about $225,000 — and if it were age 40, she’d have about $105,000.
In another compound interest example from Ryan, let’s look at two different people saving and investing for retirement.
Let’s say 25-year-old Carolina and 45-year-old Andy each save $30,000 over a period of 20 years. (For the first 10 years, they each save $1,000 annually, and for the second 10 years, they each save $2,000 annually.) We’ll assume a 6 percent annual return and that they made their contributions at year-end.
In this scenario, Carolina starts saving at age 25 and stops at 44 — and Andy starts at age 45 and stops at 64. Even though they saved the same amount and earned the same rate of return, when Carolina turns 65, she’ll have $110,000 more in her nest egg than Andy did when he turned 65. In total, Carolina ends up with $160,300, while Andy ends up with $49,970.
“Her money enjoys up to 40 years of growth from the power of compounding, compared to up to 20 years for Andy’s money,” says Ryan. “Since Andy starts saving later, he would need to save more than three times as much money as Carolina to end up with the same size nest egg at age 65.”
The kicker: If Carolina didn’t stop saving at age 44 and kept on going until 65, she’d end up with about $243,000.
“With compound interest, you want to give yourself as much time as possible,” says Ryan. “The sooner you start saving and investing for retirement and any other goal, the more time you’ll have to take advantage of the power of compounding. It’s too good to put off — it’s free money in a way.”
Read more on saving for the future:
- 6 Things to Consider Before Filing for Social Security Benefits
- HerMoney How-Tos: Where to Open an IRA and How to Open an IRA
- How to Use an HSA to Boost Your Retirement Savings
- Make Sure Your 401(k) Is On the Right Track
SUBSCRIBE: Get more money tips delivered to your virtual front door each week! Subscribe to the free HerMoney newsletter today.