If you haven’t had much of a financial education — and who has today? — the idea of calculating compound interest may make your eyes glaze over. But don’t let it! It’s important to your future, and we promise we’re going to talk about it in a way that anyone can relate to — and appreciate!
Compound Interest and You
Compound interest can be your friend and your foe. If you have yet to begin saving seriously for retirement, you may be more familiar with compound interest in its more terrifying form — the extra money you pay to banks every month for the privilege of having a house or car (or credit card debt).
With compound interest, if you owe $1,000, the amount of interest charged each month is added to that $1,000, so soon you are paying interest on $1,050, then $1,100 and so on, and this is why it can take five years to pay off a $1,000 charge on a credit card at 20% interest if you make only the minimum payments.
Interest rates for borrowing money — which are often tied to credit scores and bank accounts — can be the source of serious financial hardship, as well as prevent you from saving more toward your retirement. After all, if you can’t pay for what you need now, how are you going to save for later?
Financial guru and Washington Post columnist Michelle Singletary loves to repeat the often-used and well-loved adage: Pay yourself first. This means, make saving a priority. If you owe thousands of dollars that you’re paying interest on, it may seem counterintuitive not to put every available dollar toward paying it down, but it’s not, and here’s why.
Some purchases, such as a car, can take years to pay off. Others, like a house, can take decades. If you wait until you pay those off before you start saving for retirement, your retirement will look very different. This is the mistake that people in their 20s, and even their 30s, can make — thinking that saving for retirement is something they don’t have to worry about yet.
How Compound Interest Works
If you borrow $400,000 to buy a house at 8% interest over 30 years, you will pay more than $656,000 in interest — more than 50% more than the purchase price of your house at a total cost of over $1 million. If you’re lucky, you can get the same rate of return on your retirement account. According to Time Magazine, a 401(k) can earn you, on average, 5%-8% per year, while SmartAsset says you can expect 7%-10% per year from your IRA.
Now, the kicker here is that if you get a mortgage like the one we just mentioned, you will pay about $3K a month toward it. You likely will not put that much into your retirement account if you are just starting out. But the point we are making here is not that you can get ahead of your mortgage interest rate with hefty contributions to your retirement account, it’s that interest builds quickly.
If at age 25 you start putting $200 a month into your IRA at 8% interest for 40 years, you will end up with about $644,000. If you start when you’re 35, you get $282,000. The reduction in time you’re saving money is 25 percent, but the reduction in income is nearly two-thirds. If you start when you’re 45, you end up with a dismal $113,000.
And remember, interest rates fluctuate. That’s why homeowners refinance. Just a few years ago, mortgage interest rates were below 3%. Now they’re above 8%. This is why investors sometimes panic when interest rates drop, or one of their investments tanks and they see that number on the bottom line shrink precipitously. Time tells us that if we just wait it out, the money will return. But if you are set to retire in the middle of one of these tough periods, you may not have time to wait. That’s why it’s important to diversify.
How Compound Interest Helps Your 401(k)
We’ve mentioned how investing in an IRA over an extended period of time can lead to serious gains over the long run. This can be amplified, by taking advantage of your employer’s sponsored 401(k) plan. Many plans will have an employer match, which goes straight into your account, if you contribute as well. For example, a common employer match is the Safe Harbor Basic Match. This employer contribution will match your contributions up to a certain extent. If you contribute 5% or more of your compensation, you will receive a 4% match on top of this.
While this may seem like a small percentage, over time, this will grow into a large amount. For example, if $500 is contributed into your retirement account (which can be a mix of employer and employee contributions), at a 8% rate of return, over 40 years of employment, then one can expect an amount of $1,745,000 at retirement. Not bad!
By saving early, compound interest can work in your favor. This doesn’t need to be large amounts cashed away all at once, if money is tight. Rather, modest cutbacks and investing that money can lead to significant growth in the long term. By skipping a visit to that fancy restaurant, or cutting back on unused subscriptions, or leaving out your daily Iced Salted Carmel Macchiato, and investing this instead, then you could see $8 here or there turn into thousands in the long run.
Financial Advisors & Investing
If your employer offers the services of a financial advisor, it’s probably worth looking into. You can also do your own research, but when you set up your IRA, determine how much risk you are willing to take on. Prevailing wisdom says that the younger you are, the more risk you are able to assume because you have more time to earn the money back, should some be lost. This extra risk can be valuable, as it often pays higher returns. As you age, a portion of your investments should be shifted to more secure funds with lower returns.
The bottom line: Don’t wait. If your employer doesn’t offer a retirement savings plan, you can open a traditional or Roth IRA through 401GO in minutes. If you are a small-business owner, you can set up a plan for your employees with us almost as fast. The days when we could rely on Social Security, Medicare or other government programs to help pay our expenses in our old age are gone. It’s up to us now. Put your first $100 into your IRA and think about compound interest every time you make another contribution. You’ll be glad you did.
