Saving for retirement can feel daunting. With so many bills and expenses to take care of now, how can you save thousands, or sometimes even millions, for your golden years?
The good news is, retiring comfortably isn’t just about the amount of money you’re able to put into the market.
“When it comes to investing, it’s not only about how much money you have, but also about how much time you have to keep it invested,” Catherine Golladay, president of Schwab Retirement Plan Services, tells CNBC Make It.
That’s thanks to compound interest, which helps your money grow exponentially the longer you leave it invested in retirement funds such as 401(k) plans and Roth IRAs. With compound interest, as opposed to simple interest, money is earned on both the initial sum of money invested and the accumulated interest over time, Golladay explains.
As a result, compound interest has a “snowball effect” as your original investments and the income earned from those investments grow together, Golladay says. Essentially, it’s interest earned on interest gained.
The difference between simple interest and compound interest
With simple interest, you only earn interest on the dollars you put in, which is known as your original principal. You don’t earn interest on the dividends your savings gain. However, with compound interest, there’s interest earned both on your original principal and on the interest gained over time.
The earlier you start investing into retirement accounts, the more powerful the compounding effects will be because the money has more time to grow. That’s why it’s important to invest consistently throughout the duration of your career and avoid borrowing from your retirement funds early, if at all possible.
There isn’t a compound interest fountain of youth and we can’t go back in time. Once you miss out on the compounding interest effect, it’s lost.
Ryan Marshall
certified financial planner
“Compound interest is huge and is something you really can’t get back once you take a withdrawal,” says Ryan Marshall, a New Jersey-based certified financial planner. “There isn’t a compound interest fountain of youth and we can’t go back in time. Once you miss out on the compounding interest effect, it’s lost.”
How compounding works
To illustrate how compound interest grows over time, Scott Frank, a California-based certified financial planner and founder of Stone Steps Financial, offers a simple equation: “If I give you a penny and double it for 30 days — 1 cent, 2 cents, 4 cents, 16 cents — on the 30th day, it will be worth $5.36 million. That is the power of compounding.”
Here’s another way to look at it: “Imagine that you have two choices for an allowance as a kid: Take a penny and double it for 30 days, or get $1,000 per day,” Frank says. “Virtually all of us choose the $1,000. That is $30,000. We can do that math so easily.”
However, “what we don’t understand is that if we double the penny, we get $5.36 million on the 30th day and $10.7 million in total over the 30 days. How can this be? It is the power of compounding.”
Here’s a closer look at how those two scenarios would add up.
While the penny example is illustrative, it’s not a perfect model. Here’s how the numbers could play out in a real investment account, according to CNBC calculations: A one-time investment of $100 into a savings account with a 5% interest rate would grow to $704 after 40 years. That’s a total increase of 604%.
While that may not sound like much, if you continued to contribute $100 per month with a 5% interest rated compounded annually for 40 years, you’d have a total $145,664. However, the total amount of principal you’d have contributed over four decades would be $48,100. That’s nearly $100,000 earned from compound interest alone.
To learn more about the power of compounding, check out the following:
Like this story? Subscribe to CNBC Make It on YouTube!
Don’t miss:
Young woman smiling while working on her computer.
Getty | Thomas Barwick
