How Savings Accounts Grow Through the Magic of Compound Interest
Have you ever used any of the following excuses not to start saving for retirement?
- “I’m young. I’ll start saving in five years.”
- “Who cares if my money makes $20 in a savings account? That’s not even enough to care about.”
- “I don’t make enough money to contribute to my savings.”
When you’re young, it seems like retirement is too far away to worry about or you don’t know how to get started with a savings account. You think you have plenty of time. You think you’ll make more money and can start saving later. Even though you may have decades ahead of you and your salary is likely to increase over the years, the one thing you can’t make up for is lost time. And compound interest gives the best returns to those who have been in the game the longest.
Unfortunately, the trend is for many younger workers to not participate in the game at all. According to a survey by the CCH tax information service, less than one-third of eligible workers age 25 and younger contribute to sponsored 401(k)s. by the employer, and only 4% maximize their workplace retirement accounts. What’s more, the survey found that only 19% of younger workers planned to contribute to an IRA that year, and the majority of 18- to 24-year-olds don’t even know what retirement savings accounts they can contribute to.
Saving for retirement is simply not on the minds of most young people, and that’s a shame, because starting a retirement savings plan early can really be to your advantage.
Open a savings account now – waiting can cost you
Let’s take the following example: Sarah is 25 years old, and she decides to open a savings account dedicated to her retirement. She plans to contribute $5,000 per year, which equates to about $417 per month.
- If Sarah earns a 3% annual return and her bank offers compound interest four times a year, at age 65 she will have saved $387,095.59 for her retirement.
- If Sarah waits five years and opens the account at age 30, and still contributes the same amount and earns the same annual return, she will have saved $310,054.26 by age 65. The difference between starting at 25 and starting at 30 is $77,041.33!
- If she waits even a few more years, say until she is 35, she will only have $243,707.04 in her savings account when she retires.
Even if Sarah “catch up” on that $5,000 in missed annual contributions when she turns 30 or 35, her total won’t be as high as when she starts saving regularly at age 25. The difference is due to capitalization.
Compound interest favors young people
Sarah can see big returns starting at age 25 because of the magic of compound interest. Compound interest works like this: Over time, every dollar you invest earns interest. Then the interest you earned becomes part of your capital, and in the next period you also earn interest on that. Your interest earns interest.
It may seem like you don’t earn much at first, but short-term earnings aren’t important. It’s in the long term—in 30 or 40 years—that you’ll see big gains.
Let’s take the example of Sarah’s initial investment of $5,000. Even if she stopped putting in new money, after two years she would have $5,307.99, which means she would have earned $307.99 on her investment over those two years. However, after investing that $5,000 for 40 years, she will have a total of $16,526.42, or $11,526.42 on her first year investment. Again, this is without adding new savings. That’s a serious chunk of change!
If Sarah has invested retirement funds in an IRA or other brokerage account, she may earn even higher average annual returns—which would amplify the compounding effect—and likely receive tax benefits. in addition. Of course, with higher returns comes higher risk, but the fact is that starting early is key to reaping the rewards of compounding magic.
With the retirement savings account, every little bit counts
You might be thinking, “Well, that’s great for Sarah, but I don’t have $5,000 a year to save!” The problem with this line of thinking is that you will always wait for a “best time” to start, and in the process, you will never start at all.
Putting money into a retirement savings account is not an all-or-nothing deal. Start small, with whatever you can contribute – even saving some loose change helps! Set up automatic contributions so that the money is invested before you can spend it elsewhere. As your income increases, you can increase your contributions. If you get a raise, add to your monthly investment rather than increasing your living expenses. This prevents lifestyle inflation that often defers retirement savings further. In other words, if you get a raise and decide to treat yourself to a brand new sports car, those sports car payments will likely set you back to square one – not enough money to save for retirement.
It literally pays to start today. And one last piece of advice: once the money has been invested, don’t touch it! The magic of compound interest will only work if the money keeps growing in your savings account.
The original article can be found on SavingsAccounts.com:
“How Savings Accounts Grow Through the Magic of Compound Interest”