The Power of Compounding Interest
From the 2010 Winter Issue of the Bedel Newsletter
Remember when you took the SATs and you were asked the deceptively simple question, “If you have $100 and receive a 10-percent return for the next two years, how much money will you have at that time?” Of course, the answer chosen most often is $120. It makes perfect sense, right? But then you get home and realize finger-counting is not always the best way to solve math equations! This SAT question is a perfect example of the power of compounding interest (by the way, the answer is $121).
Many times we look at our short-term goals—buying the latest hot car, Xbox360, or 50-inch 1080P 120HZ LCD HDTV (I’ve done my research)—when we really should be focusing on the big financial picture. Whether it is saving for retirement, your daughter’s college education or a down payment on your first home, your long-term goals should always be the top priority.
Here is a prime example that illustrates the power of compounding interest. “A” contributed $3,000 per year into a Roth IRA from age 22 to age 30, then stopped, while “B” decided to wait until age 30 to start saving $3,000 per year. Assuming an 8-percent rate of return each year, it would take “B” 35 years before his account value would equal the account value of “A”. And “A” achieved that in only eight years!
The moral of that example is that you need to start saving early and make saving a priority, a mandatory thing, like paying taxes. If you don’t have a retirement plan at work, then set up a monthly direct deposit from your checking account into an IRA or other retirement savings vehicle. If your place of employment offers a retirement plan, you should always contribute to it through a payroll deduction. If your place of employment has a 401k, then contribute as much as you are financially comfortable with, but always try to make sure you maximize your employer’s matching contribution.
For example, if you can’t afford to max out your 401k annually, and your employer is offering 50 cents on every dollar you contribute up to 6 percent of your salary, then contribute 6 percent of your salary for the next few years. If you are currently living paycheck-to-paycheck, maybe Mom or Dad could give you a nice gift by making an IRA contribution on your behalf. Remember, you have until April 15th, 2010, to make a 2009 IRA contribution.
If you do not take advantage of the power of compounding interest while you are young, you are not only cheating your financial future, but you are making your retirement lifestyle or retirement date more difficult to achieve.
Contact Evan if you have questions or would like additional information regarding this topic.
