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Posted: 6:00 a.m. Thursday, June 19, 2014

Why Compound Interest Is A Saver's Best Friend

Here's how you can save less today and still retire with more



By Kali Hawlk, Contributor

ClarkHoward.com


Imagine someone told you that if you started contributing to your retirement accounts when you were 21 years old, your future nest egg would likely be worth more than if you had started contributing to it when you were 40—even if you made much higher monthly contributions when you were older.

Would you believe them?

If you knew anything about compound interest, you just might.

What Is Compound Interest?

Compound interest is an extremely powerful force that allows investors to earn exponentially larger gains on their money over time.

Let’s use a practical example to illustrate the concept. Imagine you invest $1,000 today. Now imagine that your initial investment earned a 5% gain, or $50. At the end of the year, your investment would be worth $1,050.

Your interest was added to your principal (your initial $1,000). This means that the next year, if you gained the same 5%, you’re now earning that 5% on $1,050.

You would have earned $102.50. In other words, you earned interest on the interest you already earned.

You didn’t have to do anything but let your money do the work for you. That’s how compound interest works, and why it’s such a powerful concept to understand when it comes to saving, investing, and growing wealth.

And sure, with these small numbers over a short amount of time, the $102.50 you would have earned seems pretty insignificant. But remember, you didn’t have to do anything but put a little money away to grow your wealth. When it comes to creating a nest egg, we’re talking about much bigger numbers compounding over decades.

Therefore, compound interest is the mathematical force that will enable you to save less today but still retire with more.

The Secret to Saving Less But Retiring with More

This is good news for Millennials who feel like they have about a million financial priorities to juggle. Between paying off student loans, monthly bills, and living expenses, there’s also creating emergency funds. It seems impossible to squeeze in retirement savings now, and in fact, most Millennials are saving little or nothing.

It’s certainly easy to make the excuse, “I’m too young to worry about retirement now; I’ll save when I’m older and have more to put away.”

But that’s the secret to successfully growing your wealth when you feel like you don’t have much now; in order to make compound interest work for you, you must start saving as soon as possible.

Yes, that means you if you’re in your 20s or 30s! You are in your prime investment years, thanks to your buddy compound interest. What you save and invest today is going to be far more important than the number on your paycheck that you earn 10 or 20 years from now.

Even if you feel like you can’t save and invest enough to matter right now, you can make the math work for you if you simply start. If you give your money enough time to work for you, you don’t have to feel wealthy today to meet your big retirement goals for tomorrow.

Compound Interest at Work Over Time

It may seem too good to be true, but running your own numbers will prove the importance of saving now.

For example, let’s say you’re about 25 years old and you opened your own Roth IRA today. You only have $100 per month that you can spare to put towards your retirement accounts, so that’s your initial investment. Over the next 5 years, you continue to contribute $100 per month to your account and average an 8% return.

At the end of that 5 year period, you’d have $7,186.85 in your Roth IRA.

Maybe by this time, you’ve earned yourself a raise at work. You can bump up your Roth IRA contributions to $300 per month. Another 5 years goes by and you see another 8% average return. Now your account is worth $31,679.82.

At this point, you’re 35 and ready to really knock your retirement savings out of the park. So you bump your Roth contributions again, to about $450. You continue these monthly contributions until you're 65 and ready to claim your retirement.

Your Roth IRA would be sitting at $930,514.31.

But imagine there’s some sort of parallel universe where you didn’t believe in compound interest. You weren’t worried about retirement in your 20s and 30s—why would you be? Retirement feels like a lifetime away and you’ve got other things to worry about. You can always catch up later.

Right?

Well, let’s see. Say this other version of you waited until you were 40 to start saving. You’re proud of yourself that you can open your Roth IRA with an initial contribution of $450 and your monthly additions are that same amount, right off the bat.

If we gave you the same amount of time to save that $450 a month and the same average return of 8% that we did before, what would your Roth be worth at the age of 70?

Just $616,257.54, which is $314,256.77 less than the financially-savvy version of yourself managed to save…even though the older version initially saved far more than what you could have done in your 20s and 30s.

The Most Important Element to Saving Successfully for Retirement

As our example shows, time is a critical part of reaching your retirement savings goals. If you give yourself the advantage of time by starting to save in your 20s and 30s, it will be that much easier to grow your wealth over your working years.

If you need some help getting started, focus on tax-advantaged retirement accounts first. These will net you a tax break this year, though you’ll have to pay taxes when you withdraw your money in retirement. These accounts can be extremely helpful for Millennials just starting out because if you know you’ll owe less in taxes, you’ll likely be able to make a bigger up-front contribution to your investments.

If you’re employed, ask your company about employer-sponsored retirement plans like 401(k)s, SIMPLE IRAs, or 403(b)s. Self-employed Millennials can open Solo 401(k)s or SEP IRAs. And everyone can take advantage of a traditional IRA to score more tax benefits now (or try a Roth IRA if you can max out your account so your earnings can grow tax-free).

(Editor's note: Check out Clark's Investment Guide for more background and to see his favorite low cost investment picks.)

Kali Hawlk is a freelance writer and content manager currently working on building her business and becoming a full-time solopreneur. She's passionate about personal finance, careers and business, and all things Gen Y--and she writes about it all on her blog, Common Sense Millennial. An avid runner, she enjoys getting outside as often as possible when she's not immersed in blogging and helping other small businesses build and manage their online presence. Connect with her on Twitter @KaliHawlk.