Take advantage of the power of compound interest

December 26th, 2011 Emily Schmidt

You’ve probably heard it before: “It’s never too early to start saving for retirement.”  In the back of your mind you know it’s important to save for the future, yet it probably seems counterintuitive to start saving for retirement at the beginning of your career.

Maybe you are waiting another year or two, for your next raise, until you find a new job or until you pay down your debts – but you should know that the longer you wait to start saving, the more you are missing out on the power of compound interest.

What is compound interest?

Compound interest refers to interest you earn not only on the money you originally invested, but also on any interest the investment has already earned.  Let’s take a closer look at the power of compound interest and how it can help boost your retirement savings:

Time is money – literally.

To take full advantage of compound interest, you’ll want to start early.  Waiting one year (or five years) to start saving will be costly.  When it comes to compound interest, time is incredibly valuable.  Consider this:

  • If you save $100 per month starting at age 20 (with an interest rate of 8 percent) your savings will total nearly $530,000 at age 65.
  • What if you waited 10 years? If you save $100 per month starting at age 30 (assuming the same interest rate of 8 percent) your savings will total nearly $230,000 at age 65. That is a difference of $300,000!
  • And if you waited another 10 years and started saving $100 per month at age 40, your savings will only grow to approximately $95,000.

As you can see, the power of compound interest – and the value of time – is astonishing!

Decide how much to save.

When it comes to compound interest, time is the most critical factor. But it’s also important to save regularly. In the examples above, you saved $100 per month.  In reality, the amount that you should save per month is based on your income, your spending habits, your retirement goals and what your budget will allow.  The amount of money you’ll need in retirement is also impacted by inflation, your life expectancy and your lifestyle.

If saving is not a part of your monthly budget, start by making it a priority.  Starting to save even a little money today is better than waiting until next month (or not saving at all).

Decide where to save your money.

When you’ve figured out how much to save, you’ll need to decide where to save your money. The sample calculations above assumed that you earned an interest rate of 8 percent each year. You may save your money in a tax-sheltered savings plan, such as a 401(k) or 403(b).  Other options that may be available include the traditional individual retirement account (IRA) and the newer Roth IRA.  Each type of retirement account has different tax implications and eligibility requirements, so you’ll want to consult a tax advisor to discuss what is best for you.

Get in the habit of saving each month.

Automatic deductions make saving easy. Your employer may be able to automatically deduct a portion of your paycheck to contribute to a tax-sheltered savings plan.  Your bank can also help you set up an automatic transfer to automatically move money from your checking account to your savings account each month so you don’t have to think twice about it!

Be patient and watch your money grow!

Keep in mind that all of the calculations provided above are based on the fact that you did not touch your money while it was growing. You may be penalized for dipping into some types of retirement savings early.  Plan to sit back, be patient and watch your money grow – 15, 20, 30 and 40 years down the road, you’ll be glad you did!

Emily Schmidt

About the author

Emily Schmidt is Retail Managing Officer at MidWestOne Bank. She works in the retail department, specializing in checking and savings accounts, consumer loans, auto loans and home equity loans.

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