your 401(k) #3: compound interest

“Compound interest is the eighth wonder of the world. He who understands it, earns it... He who doesn’t... pays it.”
— Albert Einstein
 

Before diving too deep into the 401(k) unit, I want to make sure you understand the difference between saving and investing. Many people use the terms interchangeably, but they serve entirely different purposes.

  • Saving
    • Putting money in a safe place for future use.
    • Stashing money in a bank account, under your mattress, or in an actual safe are all examples of saving.
    • Today, saving doesn't get you much, if any, of a return on your money. What you put in is what you get out. If I put $1,000 in a savings account today, five years from now, it'll still be worth about $1,000. 
  • Investing
    • Putting your money to work.
    • Using your money to make more money.
    • Investing is an intentional act that requires risk (no reward without a little risk, right?), and it's the not-so-secret-secret of the wealthy.
    • When you buy assets or securities like stocks or real estate, you're investing.

It's commonly said that the poor save, and the rich invest. That's because the wealthy are aware of and know how to harness the power of compound interest. The official formula for compound interest is: 

 
  • P  =   The principal value (the initial deposit amount)
  • r   =   Annual rate of return
  • n  =   Number of times interest is compounded per year
  • t   =   Number of years the amount is invested for
  • A  =   Amount accumulated after t years at r interest rate 
 

The easiest way to explain compound interest is that it's interest on top of interest. I like to think of it like a snowball effect

  • If you roll a snowball down a hill, it gets bigger and bigger faster and faster as it picks up layers of snow along the way. Same goes for the money in an investment account.
  • If you invest your money in something that appreciates, or increases, in value over time, your account balance will go up. The new value, the interest, gets reinvested and hopefully increases as well. Over time, that interest starts generating more and more interest.

It's that compounding interest that ends up doing most of the work for you. The money you originally put into the account just gets the ball rolling. If done right, compound interest can single-handedly fund your financial future. 

What do I mean by "done right"? Well, being a successful investor depends on a whole host of factors, many of which are out of our control. BUT the one thing we all have control over is when we start investing. I know you've heard that you're supposed to start investing when you're young. That's financial advisor speak 101. But do you know why you should start investing as early as possible? Here's a simple example that shows what an extra 20 years can do for you:

 

If you invest $5k and it earns an average annual return of 8%, after 20 years, your $5k will be worth over $23k. Great, right? Not so fast. If you let your money keep growing for an additional 20 years (40 years total), your original $5k will be worth over $108k! The longer you can let your money compound, the greater your overall return. The longer you can let the "snowball" (your principal investment) roll down the hill, the bigger it's going to get.

 

Now imagine you had LOTS of snowballs rolling down the hill at the same time. That's the idea behind your 401(k) and other retirement accounts. The goal is to keep putting money into your account. Think of each contribution as a new snowball. 

Here's how time and compound interest come into play when saving for retirement:

 

Let's say you're 25 years old and you put $5k into your 401(k) every year until you turn 35. So over the 10 years, you will have contributed $50k to your account. Then you stop. No more money goes in, you just let what's in the account grow over time. If your money earns an average return of 8% per year, your account balance will be over $850k when you turn 65. 

 
 
 
 

What if you don't stop putting money in at 35? What if you keep putting $5k into your account every year until you turn 65? If your money earns an average annual return of 8%, when you turn 65, you'd have $1.5 million! Seriously! Even though you only put in $200k ($5k every year for 40 years straight), thanks to compound interest, your account would be worth $1.5 million. 

 
 
 
 

What if you wait 10 years to start investing, though? What if you don't start putting money away for retirement until you're 35? Let's see. If you do the same thing - put $5k into your account every year until you turn 65 - and your money earns the same 8% average annual return, you'd only have $660k in your account at 65 years old. That's less than half of what you'd have if you started investing when you were 25! Why? Because your contributions, your "snowballs", have less time to roll down the hill. Rather than starting at the top, they start midway down. If the "bottom" of the hill is your 65th birthday, these snowballs only have 30 full years to roll down and get bigger whereas the other snowballs have 40 full years to roll. 

 
 
 

THAT is why you're constantly told to start investing as early as possible. 10 years can make a HUGE difference!

Now, I realize that these big numbers may seem crazy and unattainable, but I promise, it's not magic, it's REAL! And it can be reality for you if you educate yourself and learn how to harness the power of compound interest.

The first step in the process is figuring out how much to put into your account. That's why the next video in this unit is about contributions.

After that, you've got to know how to invest your money to earn a reasonable return. Don't worry, I'll cover the most common types of investments later in the unit!

 

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