You may think that you have plenty of time to save for retirement; after all, you are young and won’t retire for many decades! Maybe you haven’t even given any thought to retirement and figure that you’ll worry about it later, maybe when you make more. Or perhaps you are older and think it’s too late to save for the future, since it’s so close.
What if I told you that money invested now is MUCH more valuable than money invested “later,” would you believe me?
Let me introduce you to the term “Compound Interest.” According to dictionary.com, compound interest is defined as, “interest paid on both the principal and on accrued interest.” In simple terms it means that the money you earn on your investment (or savings) earns it’s own money. Let’s use a simple example to illustrate:
Suppose that our friend Bob has $100 to save. He does his research and finds a savings account that pays 10% (yes, I know this isn’t a realistic number, but it makes the math easy, so bear with me). He opens an account and deposits the $100.
One year later, Bob opens his statement and sees that he now has $110 in his account! His initial deposit earned $10. [$100×1.10=110] Bob decides to leave his initial deposit and the earned interest alone for another year.
The next year when he opens his statement, what does it say? Does it say $120? Nope! It reads $121! That extra dollar is due to compound interest; that $10 of interest he earned last year earned 10%, too. [$110×1.10=121]
This happens year after year after year, each year’s interest earning interest during the following year. If Bob left the $100, and it’s interest, alone for 40 years (i.e. age 30 to 70) he would have $4,525.93! If he instead pulled out the $10 interest payment each year and put it in a cookie jar, he would have only $400 in that jar, to go with his $100 in the bank. Pretty incredible, right?
So now you are thinking, great example, but how do I apply this to my situation? Great question, I’m glad you asked!
Once you are out of debt and have an emergency fund saved up, start saving for retirement! Some day you will retire, either by choice or due to health or a layoff. Social Security will probably not pay enough (assuming it’s still there) to support you in your current lifestyle. If you are young and start now, you should be able to retire comfortably. If you are not so young, you need to start now so you have something to help you out. Even a little bit invested now will help you out later.
Now for your financial nerds out there, I know that savings accounts don’t earn anywhere near 10%; this a very basic example of how compound interest works. Also, investments (stocks, bonds, mutual funds) don’t earn ‘interest’ but have a rate of return, which I’ll go into in much more detail in a later post, but the idea that any growth in your fund grows with the original investment still holds true.
So, are you ready to start saving?
The first time I calculated how much I needed to have saved at retirement, my jaw about hit the floor! To maintain my current lifestyle I will need to be rich!