Understanding compound interest: No math required!
If there’s one concept you need to understand when it comes to saving and investing, it’s compound interest.
Think of it this way: When you invest, your money earns a certain interest rate. And then your interest, as it’s added to the pot, earns interest on itself.
Math folks think of it as a formula:
Annual Deposit ([(1+Rate) Years+1 – 1]/Rate) – Annual Deposit = Total
Some financial types call it “The Eighth Wonder of the World.” (Okay, maybe they need to get out a bit more.)
It doesn’t matter what you call it, or whether you can do the math. In fact, a surprising new study from the University of California, San Diego and New York University, to be published in November, shows we don’t need to know how compound interest works. But what we do need to know is that it does work—in a big way. The impact of compound interest is irrefutable and beautiful—it helps your money grow exponentially (aka HUGE, so long as you just let it sit and grow over time). Think of it like a sunset: You can appreciate its beauty without understanding the speed of light, right? Similarly with compound interest: You can appreciate the beauty of interest building on interest without being a mathematician.
If you’re still having trouble grasping the power of compound interest, here’s a quick example: If you were to save $1,000 a year from age 25 to 34 in a retirement account earning 8% a year, and never invest a penny more, your $10,000 investment would grow to $157,435 by age 65. But if you don’t start saving until you’re 35 years old and then invest $1,000 a year for the next 30 years (that’s a total investment of $30,000), you’ll have only $122,346 by age 65. The bottom line: Start early, so your money has enough time to pile up.
For now, I encourage you to try out my Compound Interest Calculator. (MUCH easier than the equation above!) Enter your current retirement contributions, estimate how much you’ll put in each year and for how long, and—voilà—see an estimate of how much you’ll have waiting for you.
Now, think about your current retirement savings accounts. Ask yourself: Am I investing enough? Do I need to contribute more money? For newcomers who haven’t even *thought* about retirement yet, use this as a push to get started. Enroll in a 401(k) or contribute more to it—even if it’s just putting in 1% more of your salary. (Contribute at least as much to you 401(k) as your employer will match.) Think about opening an IRA (Individual Retirement Account) or adding $500 more to it this year than you did last year. Get in early and reap the benefits later—the not-good-at-math thing will just be between you and me.
