The Magic of Compound Interest

(Become a Millionaire)

If you’re starting from scratch and want to be a millionaire by middle age, you have some planning to do. The more money you put in and the longer you keep it invested, the faster you’ll reach your target.

Even though you’ll likely earn a higher salary later on, now is the most crucial time to invest as much as possible. In fact, if you invested during the first 10 years of your career and then stopped contributing, you could have more money than if you wait 10 years to start.

You can only work with what you have. But be honest with yourself. Could you trim your expenses a bit to increase your 401(k) contribution (at least to your employer’s match level) or open an investment account? Believe it or not, every little bit makes a huge difference when you’re young, thanks to the magic of compound interest.

HOW IT WORKS

Let’s say you start with $100. You have an account with a 5% interest rate that compounds once a year. The first year, the interest rate is calculated as a percentage of the beginning balance, but each year afterward, the interest is figured on the beginning balance plus the interest. For example:

Beginning balance: $100
Year 1: 5% interest on $100 = 100 x 1.05 = $105
Year 2: 5% interest on $105 = 105 x 1.05 = $110.25
Year 3: 5% interest on $110.25 = 110.25 x 1.05 = $115.76

COMPOUNDING PERIODS

The more often the interest is compounded, the higher your balance. You would earn more on a 4% interest rate that is compounded more than once a year (semi-annually) than on an 8% interest rate compounded annually.

Beginning balance: $100
4% interest compounded semi-annually:
First compounding period: 4% interest on $100 = 100 x 1.04 = $104
Second compounding period: 4% interest on $104 = 104 x 1.04 = $108.16

8% interest compounded annually: 100 x 1.08 = $108

Each time the interest is recalculated, it uses the old balance plus the newly accrued interest. The more you start with, the bigger and faster money grows. Even though 8% sounds better, the additional compounding period makes all the difference.

MORE MONEY GROWS FASTER

The more seed money you start with, the more interest it will generate. The interest grows more interest. And, if you keep feeding your investments with new money on top of the original investment, the interest has more to work with.

Choose investments that allow your money to grow at a comfortable rate for you. If you don’t want to take the risks needed to aim for an 8-10% return, you can invest in slower growth products, like bonds, that are less likely to lose money (if you hold them to maturity). Your money will be safer, but you also will have to contribute more if you want to reach a big number before you retire (at whatever age).

Plug numbers into a compound interest calculator and play around with varying rates of return (4%, 8%, 10%) over different time periods (10, 20, 30 years). What happens if you increase your contributions each year? If you contributed $1,000 last year, what if you contribute $1,050 this year? Over time, these slight adjustments can give you impressive results. And, yes, you might even be a millionaire — but you will have to make some sacrifices to get there.

As always, we’ve got your back. — The On Your Own Team End of article insignia



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