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HomeBlogHow Does Compound Interest Work?

Everyone has their own ideas and plans of what they want to do in retirement, and we all want to get there someday. The biggest question many us ask is, how do I build the assets necessary to fund my retirement dreams? The answer to that question can lead to more:

• How much should I save?
• How should I invest my savings?
• What type of accounts should I use?
The list can go on and on…

We can’t answer all those questions here, and it’s important to understand that the answers are unique to each investor. However, I do want to talk about one of the most powerful tools we can use to build our retirement income – compound interest.

Albert Einstein called compound interest the eighth wonder of the world. Coming from someone like Einstein that must mean something, so how can it help us build retirement savings?

Let’s start by talking about the difference between saving and investing because they are not the same thing, but we must do both in order to give ourselves the best chance to meet our long-term income goals.

Saving is simply setting money aside in safe place. It is a passive act. Under your mattress or buried in the yard are two examples, but a bank checking or savings account is a better option. You’re not spending your money, you’re setting it aside for a later date when its needed.

Investing is putting your money to work for you with the intention of using your money to earn more money. It is an intentional act. Investing is buying something, like shares of company stock or a mutual fund in your 401(k) plan, with the idea that it will increase in value. Investing requires at least some level of risk. It also requires a level of discipline and patience to be done properly over time.

To take advantage of the power of compound interest, we must both save and invest. Save to have money to invest and then invest to earn the interest that can compound, or grow, over time.

So, what exactly is compound interest, and how does it work? It’s simply the idea that our money makes money over time. If I invest in something that goes up in value, I’ve earned new money, or interest. My interest gets reinvested, and over time, my interest starts to earn interest of its own. Interest on top of interest.

Think of rolling a snowball through the snow. It grows on itself. The farther you roll it, the bigger it gets. Compound interest works in a similar way. The more time we let our money grow and reinvest, the more it can grow.

As an example: If I invest $2,400 today and it earns 8% in 20 years it will have grown to over $11,000 ($11,189). If I let it grow for forty years, my $2,400 grows to over $52,000 ($52,150). My smaller initial contribution has grown into a rather large snowball.

Now think about your 401(k) and making contributions to it each month. These contributions are snowballs that can potentially grow and compound over time. Stay with that same 8% return, if I contribute $200 a month to my 401(k), in twenty years my account is worth over $113,000 ($113,824). If contribute and my 401k grows for forty years, my balance is over $644,000 ($644,352). By simply saving $200 a month for forty years would result in $96,000, but by investing along with the power of compound interest, my $96,000 could grow into $644,000.

You can see why Albert Einstein thought so highly of compound interest. The lesson is that compound interest is a powerful tool, and time is one of our most valuable assets. We want to take advantage of the time that each of us has and put compound interest to work in our retirement accounts.

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