How Saving and Compound Interest Helps Your Financial Plan
Hi everyone! Welcome back to Melissa Making Cents!
As I look back on advice I have been given in my life, there are few pieces that, in hindsight, I should have taken. One of those pieces of advice was to invest early. As a CERTIFIED FINANCIAL PLANNER™ and financial coach, it's a case I plead often with younger clients! When you are young, the battle between saving and fun is fierce! The mindset that we have plenty of time to save hurts our financial plans, and it's possible to wake up one day and realize time is not on your side!
In fact... I now feel like that one relative that everyone has in the family that harps on saving money. I'll take this moment to shout out to my sweet niece, Alex, that had "the talk" with me today!
I have a riddle for you. Suppose you won the lottery, and you were given the option to accept one million dollars right now, or receive a penny doubled every day for 30 days. Now, the choice might seem obvious: one million dollars is much more than a penny! But if you stop and think about it, a monetary value (even a small one) that keeps doubling every day should amount to a nice chunk of change in the end. In fact, if you calculate a penny doubled every day for 30 days, it would look something like this:
That’s more than five million dollars by the end! Financial experts often use the “penny doubled” riddle as a way to show the power of compound interest. Today I’ll explore the concept of compound interest and why it pays to start saving (and investing) early.
Compound interest is the addition of interest to the principal of a loan or deposit, so that interest accrued going forward is earned on the principal plus previously accrued interest.
Wow, that definition is a mouthful! So let’s break it down.
Whenever you open a financial account, the first deposit you make is known as the principal. Let’s assume you opened an IRA on January 1, 2020 and put in $1,000 as the principal. Let’s also assume that you didn’t put any more money into the account for the rest of the year.
Over the course of the year, let’s say the average rate of return was 5%. That means that on December 31, 2020, there will be $1,050 in the account (the $1,000 principal plus the $50 that was accrued in interest).
Even if you don’t contribute any more to the account in 2021, the money is still going to grow according to the annual rate of return. So if our hypothetical average rate of return is still 5% in 2021, your account will have $1,103 on December 31, 2021. This is calculated by multiplying the current principal of $1,050 by the 5% rate of return. So, your interest is earning interest!
Of course, you should still be making contributions to your financial accounts every month so that your money continues to grow. But compound interest can be your best friend in the long run, and the amount of your compound interest may even exceed your personal contributions!
Saving money early is essential for growing your investments through compound interest.
Compound interest is a slow process, and you won’t see dramatic results right away. Think about the penny doubled example. It took more than a week to earn a full dollar! But after that, it reached $100 after about two weeks, then $10,000 after three weeks, and $1 million after four weeks. This is why it’s so important to start saving early so that compound interest has the time to work its magic.
Let’s look at another example. Suppose at 25 years old, you start putting $1,000 a month into a retirement account and earn an average annual rate of return of 5%. If you save that money for 20 years, your portfolio when you are 45 will be worth $419,417: $253,000 from your individual contributions and $166,417 from your compounding interest. Even if you stopped making contributions to the account when you are 45, your interest would keep accruing. By the time you are 65, your portfolio will be worth $1,112,839, of which $419,417 came from your individual contributions and $693,422 came from compound interest.
Of course, there are several factors that go into how much you will eventually earn in compound interest, including the amount of your principal, the amount of your contributions, the rate of return, the time span, and whether the interest is compounded annually, monthly, or daily. Want to see the power of compound interest for yourself based on your own financial situation? Use a compound interest calculator and plug in your own numbers. For reference, the annual average rate of return for a 401k portfolio fluctuates between 5% and 8%. (of course... past performance is never a guarantee of future performance! Consult an investment prospectus before purchasing)
Working with a financial coach or a financial planner can help you find ways to save that money.
If you’re thinking that you don’t have enough money to start saving and investing early, or if you’re afraid that it’s “too late” to start saving--that’s what financial professionals are for! As a CERTIFIED FINANCIAL PLANNER™ and a financial coach, I’ve helped my clients develop plans around budgeting, saving, and investing to better position themselves for retirement in the future.
If you want to learn more about my new financial coaching program Making Cents of Your Money, or if you want assistance in learning how to save and make the most of compound interest, please call or email to schedule an appointment with me.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor, and Financial Coach in Dallas, Texas.