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. But what is compound interest and why is it worth investing in? Here’s what it is and compound interest examples to show you the upsides of it.
What Is Compound Interest?
The gist: You save a little money at a time and automatically invest it 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. Over time, compounding can add a lot of value because you have 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.”
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Why You Need Compound Interest Right Now
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 work 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 start 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. Try to find a few dollars here and there to save. Every little bit helps in the long run. For one compound interest example, if a 25-year-old started investing $200 per month and we’re assuming a 6% return, by the time they turned 65, they’d have a nest egg worth $393,700, according to 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 starting sooner? It’s smart to invest during a market correction 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.”
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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. This means she could end up with around $32,000. (This assumes a 7.2 percent growth rate, which Ryan says is reasonable).
But what if Sarah waited another 10 years 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.
Consider that if Sarah were to invest that $1,000 at age 20 and contribute $83 (or $1,000 a year) a month until retirement, she’d have $465,000 by the time she turned 70.
If she did the same but waited to start until 30, she’d end up with about $225,000. 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. 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. Andy starts at age 45 and stops at 64. Even though they saved the same amount and earned the same rate of return, their earnings are different. 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.”
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.”
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