Any financial planning textbook will tell you to save AND invest your money, and to do it as soon as possible. The real key here is to act early in life to take full advantage of compound interest later in life. In very simple terms, compound interest is both the interest accumulated on the principal (or the original amount invested) and on the interest earned from previous years. For example, let’s assume you have $1,000 and you place it into an investment that earns an eight percent return every year. After the first year, you would have $1,080 (the original $1,000 plus the $80 in interest you earned in year one ($1,000 x 1.08). Then, in the second year, your $1,080 grows to $1,166 ($1,080 x 1.08), and so on.
Compound Interest Example
Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” In other words, start now. Over time, the more interest you earn, the more your interest earns interest. The table below gives you a better idea of how compound interest affects a measly $1,000 over 50 years.
Compound Interest in Later Years
Impressive, right? You earn $80 in interest in the first year, but by Year 50, without doing anything but waiting, you earn $3,474 in interest. Likewise, you turned that $1,000 into $46,902. To put it simply, the longer you give your money a chance to compound, the more you will have in the end. As you can see from the graph above, the compounding in the later years is much greater than in the earlier years. This is why everyone says to start investing early. The sooner you get started, the longer your money is compounding, and the more you will have later in life.
If you were to put your $1,000 into that investment when you were 20 years old, by the time you turn 70, you would have $46,902. On the other hand, if you put $1,000 into that investment at age 50, you’d be 100 years old, or more likely dead, before your money grew to $46,902. I’m not saying you won’t live to be 100, but you get what I’m saying…the sooner you start investing, the better.
Save and Invest as Often as Possible
Now, let’s also assume you save $1,000 in every year rather than just the first year.
Compound Interest and Saving Consistently Over Several Years
|Year||Beginning Balance||Amount Saved per Year||8% Interest||Ending Balance|
In this instance, you would have significantly more money in 50 years. In fact, in Year 50 you would have $619,671 rather than $46,902. So it makes sense to not only save early but to save AND invest often.
I’ll say it again. Start saving and investing now and often.
Let’s look at the negative effects of beginning to save later in life again. Look at the next two graphs (Figure 5 and Figure 6). Figure 5 relates to an example where, between the ages of 22 and 72, you have saved and invested $1,000 a year, earning an eight percent return on your investments. The second graph assumes that you start later in life and only saved and invested $1,000 a year between ages 35 and 70. The only difference is that you start at age 35 rather than 22.
Based on these data, you will earn approximately $400,000 less by waiting 13 years. Think about it for a second. You save $1,000 a year beginning at age 22 rather than 35, and you have an extra $400,000 by the time you are 70. While $1,000 a year at 22 may seem like a lot, it isn’t that much money. And, personally, I would rather have that extra $400,000 at 70 than save the $13,000 ($1,000 a year from 22 to 35). Compounding, saving consistently, and starting early are the most powerful tools you have in accumulating wealth. It’s that simple.