Compound interest makes a certain amount of money grow faster than the use of simple interest. This is simply because, in addition to earning returns on the money that one invests, one also earns returns on those returns at the end of the compounding period. The compounding time can be either annually, quarterly, monthly, or daily, depending on an individual choice or goals. Compound interest is calculated on the initial principal and also on the accumulated interest of previous periods. Think of it as a cycle of earning “interest on interest.” Its approach makes the loan or the deposit grow faster.
How can you make it work for your retirement goal?
In the old days, people would hide away the extra amount of money they have in their mattresses. This was not a good idea, especially if the house would get on fire or flood. However, it was the best option they knew. Fortunately, today, there are many reliable alternatives to store money. The alternative options provide stability, security, and, most importantly, the bonus of earning interest and compounding the value of the money. This means that there will be an increase in the amount saved for retirement.
With compound interest, one can build their saving at a faster rate and even save more, making it a great approach to use for the retirement goals. An investment left untouched for a long time can add up to a large amount of money. The nature of compound interest occurs when the interest earned from the money invested is re-invested to earn more interest. By earning interest on interest, the retirement savings account has the potential to snowball over time. With this, one will not need to put aside much money to reach their retirement goals.
Savings account amount | Rate | Interest fund | Year-end account balance | |
Year 1 | $ 1,000.00 | 7 % | $ 70.00 | $ 1,070.00 |
Year 2 | $ 1,070.00 | 7 % | $ 74.90 | $ 1,144.90 |
Year 3 | $ 1,144.90 | 7 % | $ 80.143 | $ 1,225.043 |
How compound interest can grow a savings account
If individual places $1,000 in a retirement account with a 5% interest rate, at the end of Year 1, they will have earned $50 in interest. This will increase the total savings of $ 1,070.00. In the second year, compounding kicks in, and at the end of the year, they will earn 5% interest on $ 1,144.90. This results in an increase in the account balance of up to $ 1,225.043.
Letâ€™s take an example of two people who invested $ $5,000 with a return investment interest of 7 % annually.
Esther invests $5,000 per year at age 18 and continues investing until retirement at age 58. The investment had an annual investment return of 7%. And at the end of 40 years, she invested about $200,000.
In another case, Eric started investing the same amount of money, $5,000 at age 28. He continues with the investment until age 58, where he stops due to retirement. The investment is about 30 years adding up to a total of $150,000, with a 7 % annual return investment.
Therefore, Esther, who started investing at a young age, the investment is higher than that of Eric. In the same case, Eric’s investment amount is also high. But with compound interest, Esther is more favored since she starts earlier than Eric. It is never too early or too late. However, saving earlier gives one a huge edge on their finances and ensures that their retirement life will be less stressful. The power of compound interest can make you rich. With this in mind, saving early is critical in meeting the retirement goals as it reduces the need for one to contribute large sums to the savings.
There are different retirement options that individuals can use, like putting aside money in a qualified plan (such as a 401(k), setting up a retirement plan if employed and opening up a traditional or Roth IRA if you’re eligible, etc. However, in any option chosen, with compound interest the earlier one invests, the more the benefits. No matter the option, the most important step is to open at least one account and start contributing to it consistently to take full advantage of compound interest.
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