If You Still Don’t Believe In The Power Of Compound Interest, You Have To See This

By Alaina Tweddale February 27, 2015 Posted in: Investing

Invest young and the power of compound interest will make you rich. Really? Yes, really. Here’s a super-simple example that will knock your socks off.

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Student loan debt. Lousy job prospects for recent grads. Wage stagnation. High costs of living.

Do you ever feel like — when it comes to getting ahead financially — the deck is stacked against you?

True, it’s not easy being a 20-something in today’s economy. But you have one thing going for you that has your Baby Boomer parents jealous.

Time!

If you’re under the age of 35, you have one of the biggest advantages out there when it comes to planning for eventual financial freedom.

How much you can put away per month is important but, as the numbers below show, that number pales in comparison to how much time you can invest in your plan. In other words, the sooner you start, the greater the advantage you’ll have.

Don’t believe it?

Check out the chart below, which plots the savings strategies of three fictional investors, each of whom saved the same amount of money over a 10-year term.

Through an incredible stroke of investment luck, each earned the same average annual return (seven percent) consistently, until age 65. The only difference between these investors is the year when they start socking away their funds. If you ever plan to retire (and who doesn’t), you should be amazed by the results.

The data doesn’t lie

Michael saved $1,000 per month from the time he turned 25 until he turned 35. Then he stopped saving but left his money in his investment account where it continued to accrue at a seven percent rate until he retired at age 65.

Jennifer held off and didn’t start saving until age 35. She put away $1,000 per month from her 35th birthday until she turned 45. Like Michael, she left the balance in her investment account, where it continued to accrue at a rate of seven percent until age 65.

James didn’t get around to investing until age 45. Still, he invested $1,000 per month for 10 years, halting his savings at age 55. Then he also left his money to accrue at a seven percent rate until his 65th birthday.

Michael, Jennifer, and James each saved the same amount — $120,000 — over a 10 year period.

Sadly for Jennifer, and even more so for James, their ending balances were dramatically different.

SAVER	ENDING BALANCE
Michael	$1,444,969
Jennifer	$734,549
James	$373,407

How on earth can I save that much?

I know what some of you are thinking. $1,000 per month sounds like an awful lot for a 25-year-old to save. I hear you. It is a lot. But, it’s not as much as you think.

According to the National Center for Education Statistics, the median annual earnings for a college-educated young adult (aged 25-34) is $46,900. At that income level, a $12,000 annual investment represents 13.33 percent of income, and that’s before the tax advantages of your employer’s retirement plan are considered.

If your employer offers a 401(k), 403(b), or some other tax-advantaged retirement plan, the money you put away is invested on a pre-tax basis. This means you won’t pay income taxes on your retirement savings until you take the money out at retirement (when your income and therefore your tax burden are likely to be lower).

What does this mean for you now, in the immediate present?

If you’re putting away $12,000 a year in your company’s 401(k) plan, you’re not actually losing that full amount from your take-home pay. Instead, assuming you’re paid every two weeks, your take-home pay will reflect a $346 decrease, assuming you’re a single tax filer in the 25 percent tax bracket.

Thanks to the power of compound interest (the investing magic that allows investment earnings to earn interest of its own), time is the most powerful variable a young investor has on his or her side. Sure, your baby boomer parents might bring home a much higher income, but if you start now, the amount you’ll have to save to fund your retirement is dramatically lower.

Almost $350 per pay period isn’t chump change, for sure, but it is do-able. In fact, do it for 10 years and you might choose to never do it again. You might not have to.