The Power of Compounding Interest

Jun 20, 2010

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 ($16,500 for 2010), and your employer is offering a one-to-one match on every dollar you contribute up to 6 percent of your salary, then contribute 6 percent of your salary for the next few years until you can afford more. 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 ($5,000 maximum for 2010). Remember, you have until April 15th, 2011, to make a 2010 IRA contribution, so no hurry, but compounding interest can be a powerful thing.  A wise man once said, “Compounding interest is the most powerful force in the universe” -Albert Einstein

I truly believe that 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.

Please share your thoughts and ideas with the group.  We can all learn from each other!  Thanks.

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