The 8th Wonder of the World… Compound Interest
Compound interest - a novice concept that most know about but fail to realize how powerful it truly is. Compound interest is so impactful it can be the difference between having a second house in retirement versus worrying about not having enough money to live off in retirement.
Compound interest is defined as interest calculated on the initial principal, which also includes all the accumulated interest from previous periods on a deposit.
If you truly understood the power of compounding interest, then you would probably work extra hard to put away extra spending money each month and invest it.
Take for example, if you were to accumulate $100,000 in an investment account by the age of 40 and let it grow by an average rate of return of 8% you would have a balance of $684,847.52 by age 65. Now consider investing an additional $6,000 annually between the ages 40 to 65, with compound interest, by the age of 65 - you would have $1,117,483.16.
The difference of the additional earnings of $432,635.64 is by adding $150,000 more to your investment total over that 25-year period.
Your money is compounding even if you never were to add to it again. This is an important concept to understand. It seems simple, but most don't understand what compound interest means and how it works. It is important to continue saving, but which vehicles you choose to save can make all the difference in the world of what your future may look like.
Take for example Client A who is age 30 and decides to save $6,000 into his retirement accounts per year and spend the rest of his money on present day goods and activities. He would wind up with $1,679,964.96 in his retirement account which is a very sizable amount. The caveat, however, is that he is not going to be able to access this money until age 59 ½. Now that may be a fine scenario to wind up with as he has more than $1.6M in retirement assets, but he is now locked into age 59 ½ before he can begin to draw down on his assets without penalty or restriction.
Now consider Client B who is also 30 and decides to do exactly like Client A and save $6,000 into his retirement accounts. Client B is on track to accumulate the same amount of assets. The difference is Client B decides to save an extra $10,000 each year and averages an 8% annual return. By doing so he also accumulates an additional $494,229.21 at age 50 or $789,544.15 at age 55 in a brokerage account or a non-retirement account. Now the reason this is important is because Client B has much more flexibility of when he wants to retire or what his life may look like. All he had to do was save additional money today for more flexibility tomorrow.
What can we learn from Client B? Not only the importance of saving and investing as much as we can, but to save into a brokerage account outside of your retirement account. Most people miss this in entirety and decide to only fund retirement accounts which is a great place to start. However, it greatly limits your flexibility in the future.
If you look into the future, do you know what your life will look like in terms of when you will retire, what kind of financial situation will you be in, where will you live, and how will you spend your days? Many people don't have clear answers to these questions.
Saving and investing in an account that provides flexibility will afford you the ability to give yourself choices in the future and allow more financial freedom.
So, start today, determine how much additional you can save weekly, monthly, and annually; invest it. Your future self will thank you later when you are afforded many opportunities and choices then you would have had otherwise.