Why Saving Early On in Life is Underrated
For many young people, knowing to avoid paying excess interest on a credit card or other loan is not anything new. It’s also not a newsflash that earning interest through savings accounts, 401k or IRA plans, and other investments is a plus.
What may come as a surprise to some though is how much of a difference several years can make in terms of how interest grows over time if left untouched in an account.
To illustrate exactly what we’re talking about here, we’ll look at the difference between simple interest and compound interest, then go through an example of each. (Also note that in each example, interest is paid at the end of the given time period.)
This is interest that’s paid out at a given percentage once a period, and only takes the original principal value into consideration. No matter how much interest you earn over time, this interest can never earn interest itself. While it certainly earns us money, this isn’t the type that’s going to be exactly what we’re looking for in savings.
For example, let’s say you sign a lease to rent an apartment, and the conditions require you to put down a security deposit of $1,500. At the end of your time in the residence, provided all goes smoothly, you get this money back. With this security deposit though, you also earn simple interest on the $1,500.
If you earn 3 percent simple interest every year you live there, and you stay for five years, it would look like the following:
- Year 1 - $1,500 x 3% = $45
- Year 2 - $1,500 x 3% = $45
- Year 3 - $1,500 x 3% = $45
- Year 4 - $1,500 x 3% = $45
- Year 5 - $1,500 x 3% = $45
So, each year you earn $45, or $225 over five years. At the end of your stay, you would receive a check for $1,725, which is your $1,500 security deposit, plus interest earned of $225.
You could stay in the same place for 50 years and earn 3 percent off of this security deposit; however, you’ll never earn more than $45 per year, since the interest is calculated from the initial deposit only. And that is not going to earn you all that much over time.
There is, however, another way to look at interest, and that’s compound interest. With this type, the interest is paid on the sum of money in the account regardless of if the money is principle or interest that was earned off of that principle.
Here’s an example:
You invest in an account that over several decades earns you an average of 5 percent annually. (While there are certainly investments that can earn more or less, 5 percent is the number that will be used for illustrative purposes.)
Also, why several decades? Because compounding interest works best when stretched out in many, many years, not just a few of them.
Here’s the breakdown:
Let’s say you start investing $200 per month in this account when you’re 45 and retire at 65, which is when you stop actively contributing to this particular fund.
Your total principle invested is $48,000, which earns you $31,358.29 in interest, or $79,358.29 total.
Now let’s say that instead of starting at 45, you start at 35. What happens there?
Your total principle invested is $72,000, which earns you $87,453.23 in interest, or $159,453.23 total. In essence, for an additional $24,000 in principle that you’re investing, you’re earning an additional $56,094.94 in interest. Not too bad.
Let’s look at one more to see how compound interest can really be a benefit if you have the idea, planning and discipline to start early.
Instead of 35, you start at 25. This allows for 40 total years of growth, which yields the following:
Your total principle invested is $96,000, which earns you $193,919.46 in interest, or $289,919.46 total. Just by starting 10 years earlier, you’re able to generate more than double your principle in interest. That’s really amazing.
Here’s a breakdown to illustrate the same point to the more visually inclined:
This also uses only $200 per month in our example. While that number may be all that you can afford now, increasing it as soon as you can would enable these funds to grow even more rapidly. Add in an employer match in a 401(k) plan, comprehensive care plan and a little bit of Social Security, and you could be well on your way to a very comfortable retirement.
Compound interest: Learn how it works early on in life and it can be one of your best friends on your road to a financially prosperous future.
If you have any questions on investing for the long-term and how to best get started, and you want to discuss your situation with a Certified Financial Planner ™, contact me directly.
This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
This is a hypothetical example for illustrative purposes only. It is not intended to reflect the actual performance of any security. All investments involve risk and you may incur a gain or a loss. Your results will vary from those listed here.