The Power of Compound Interest

The other day I wrote about some of the benefits of the 401k. Today I’ll go over what really makes investing important and worthwhile: compound interest.

The basics:
Interest is a fairly simple idea, and most people understand it on the surface. If I invest $2,000 dollars for a year earning 1% interest I’ll have $2,020 at the end of that year. This includes my initial $2,000 plus $20 in interest. Now here is where compounding starts to work. If I take the $2,020 and invest it for another year how much will I have at the end of year 2? If you guessed $2,040 you’re close. I’ll actually have $2,040.20. I know what you’re thinking. Woohoo, a whole twenty cents more. Granted, it isn’t a lot, but you didn’t have to do any additional work for that $0.20. It represents interest earned on your interest.

What’s the big deal?
Compounding may look insignificant at first, but over a period of years it really adds up. Going back to our previous post a person that invests $5,000 a year from age 30 to age 60 earning 7% (a reasonable assumption for long-term stock returns) will have $472,304. If the same person invests $5,000 a year from age 35 to age 60 earning the same 7% they will have $316,245. That’s a difference of $156,059. But one thing we notice is that the difference is more than just the sum of five years worth of contributions ($25,000). The reason for this is because not only is the second example missing out on five years of investing, they are also missing out on the compound interest earned on those investments.

What this means:
We’ve all heard that the earlier you start investing for retirement, the better off you’ll be. Now you know that this isn’t only because of the extra years of investing, but also because of the compound interest earned on those extra years.

The 401k

When it comes to retirement planning, perhaps the most important step is to take advantage of your employer’s 401k plan.

The basics:
The 401k is named after an obscure section of the federal tax code. It allows you to set aside dollars on a pre-tax basis into an account for retirement.

Tax-deferred contributions:
So, lets say you make $1,000 a week and contribute 5% of your pay into your 401k. This comes out to $50 a week. But since it’s taken out pre-tax, the net effect on your take home pay is only $42.50 (if you’re in the 15% marginal tax bracket). This is because that $50 contribution lowers your taxable income. Now you can’t avoid paying taxes on this entirely, but you won’t have to pay them until you withdraw funds at retirement.

Employer match:
One of the best features of the 401k is that the majority of companies match a portion of your contribution. For example, my employer matches my contribution up to 4% of my salary. In other words if I contribute 4% of my salary, the company kicks in another 4%. This is essentially free money from my employer. I know that not all employers have a match and that not all matches are that generous, but every little bit helps.

Automatic investing:
Another great feature of the 401k is that contributions are automatic. You don’t have to consciously decide to contribute every payday. We all know that it’s a lot easier to spend money than it is to save it. With automatic contributions you can make sure that you are investing regularly. And what’s better is that after a while you get used to the size of your paycheck. You’re a lot less likely to think, “My paycheck is $42.50 less” after a month or two of regular contributions.

The power of time:
The earlier you start investing, the more you’ll have for retirement. This idea is intuitive to most people. People understand that they’ll have more by starting earlier. If I invest $5,000 a year for 20 years it equals $100,000. If I invest $5,000 a year for 30 years it equals $150,000. But there’s more to investing than just your contributions. No, it’s not magic… It’s compound interest, and we’ll explore that in the next post.

The “What-if-something-happens-to-me” File

Over the past few weeks, we’ve seen several status updates on Facebook from a couple we know.  They’re in their 30’s and have a daughter that is around six months older than our son.  The husband has been in ICU at the hospital for two weeks now and doesn’t look to be getting better soon.  The doctors aren’t sure what caused all this, but he’s on a ventilator and his brain functioning has dropped off significantly.  They are moving him to a longer-term facility next week.  They’re a really great couple and we feel for them.  We’re praying for a full recovery.

My wife made the comment today to the extent of:  “If something like that happened to you, I really don’t know what I’d do.  I mean with the bills and stuff.  You do all that on-line, and I have no idea what you do.”

This got me thinking that I really need to put together a “what-if-something-happens-to-me” file.  In our family, I take care of the finances.  This includes balancing the checkbook, paying bills, transferring money into different accounts, etc.  I think most households do something similar, with one person primarily responsible for keeping the books.  I’m an accountant by trade, so in our family this naturally falls on me.

So, if something happens to me, and I’m unable to keep up on the finances, my wife needs to be able to keep the mortgage paid and the electricity on.  I’m putting together a file that will make this easy for her should such a situation arise.  Here’s what it contains:

  • A listing of every regular bill we have, its due date, and the typical average amount due
  • A listing of on-line account logins and passwords (since I pay all our bills on-line and use on-line banking)
  • My e-mail login and password (since I receive a number of bills via e-statement)

This list should make it easier for my wife to keep things going if something happens to me.  However, as I was going through this process I found a number of things I can do to make it easier on her.

Automate Monthly Bill Payment

I have a few of our bills set up on auto-pay, where the company automatically withdraws funds from my checking account on the bill’s due date.  Not only is this very convenient, but it also ensures that I never accidentally miss a payment.  I have the auto-pay option on virtually all of our bills, so it would take a matter of 15-20 minutes to sign up for this with the rest of my bills.

Educate My Wife

Another thing I can do now is go through the process with my wife.  I can walk her through how I pay the bills each month, what websites are used, and just give her a feel for what it’s like.  This way if something did happen to me, all the bills wouldn’t be so overwhelming.

Keep This File in a Safe Place

One last thing I can do is keep my “what-if-something-happens-to-me” file in a safe place.  I would not feel comfortable keeping a file like this on my laptop.  I like to think my wife and I are careful when we’re on the internet, and I keep up-to-date antivirus software on our computers.  But I don’t want to risk some hacker getting access to all our financial accounts.  So, I can instead print out this file and keep it with our other important papers.  For us, that would be in our fire safe along with things like our vehicle titles, insurance policy documents, birth certificates, social security cards, etc.

Now, hopefully this file will never need to be used.  But at least if it does, there will be a few less things my wife will have to worry about.

First Blog

The past two days my wife has been sick, running a mild fever, coughing, and just feeling really tired and weak. So, I’ve stayed home to take care of the little guy. The last thing we want is for him to catch what my wife has.

I thought I’d use this as an opportunity to introduce our family. I like to think of us as a pretty normal family… Husband, wife, baby boy, and a dog. I work at a local bank in the accounting department, and my wife is a stay-at-home mom to our soon to be one year old.

I grew up in a pretty poor family (free lunches and textbooks at school, no money for extracurricular activities, lots of ramen noodles and macaroni & cheese for dinner). Looking back now that I’m an adult with a family if my own, I can see that things didn’t really have to be that way. There are things we can do to make a better situation for ourselves, and that’s what I’ve done. Granted, I have not “arrived” at that point where money is no object, and I never will. But you can have a great life without being rich. It’s all about doing what’s important to you, and focusing your money and energy on those things.

I am blessed to be employed by a company that provides sick days to allow me to stay home today and take care of our son.