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.
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.