Compound interest: Why it’s never too early to get started on retirement
Mathew Carrick / Columnist
Albert Einstein supposedly once said, “Compound interest is the most powerful force in the world.” Whether or not Einstein actually said it, the statement is true: compound interest is a force of nature—and a compelling argument for saving early.
When you save money in a bank, your deposit earns interest, or money paid regularly in the form of a percentage. If your account gives you “10 percent interest,” that means that every year 10 percent of the amount you’ve saved gets paid to you by the bank. If you start out with $100, then after interest is paid you’ll have $110. The next year, your interest payment will be $11 (10 percent x $110), and you’ll have $121. Interest payments are compounded, or stacked on top of one another.
Here’s where compound interests power comes from: every year, your interest payment will get larger and larger. If you were to make a graph of your annual savings, it would be exponential, starting out slowly but eventually building up.
Many college students think it’s too early to start saving for retirement and old age, but that’s not true. It’s never too early! Because compound interest gets more powerful with age, beginning earlier will lead to more substantial savings later. $1,000 compounded continuously, or growing perpetually, at 7percent—roughly the average long-term return for stock investments—will become $2,000 in 10 years, $4,000 in 20, $8,000 in 30, and so on. A good rule of thumb is the “Rule of 70:” 70 divided by the rate of return (7 percent) equals the number of years it will take an investment to double (10). You can see the benefit of starting early!
But what if you can’t afford to start saving now? In the vast majority of cases, people can afford to save now. Taking the time to do so, even a little bit, will pay in the future. Even $10 saved a month—the price of about 4 cups of coffee at Arctic Java—can grow to $24,000 in 40 years. If you stuffed that money under your mattress instead of investing it, then after 40 years you would have less than $5,000.
This raises a good question, though: why does money earn interest? Why would any bank give you that extra $19,000? In a bank’s case, interest is paid to encourage individuals to save. The bank still makes money because they actually use some of the money saved for other projects that will generate them revenue. Don’t worry though, your money is insured and isn’t going anywhere.
In investing, where you might see that 7 percent annual return, your money doesn’t really grow because of payments, but because what you’ve invested in gets better. I might invest by purchasing stock in Coca-Cola—in other words, by giving some money to Coca-Cola so that they can expand their business. As Coca-Cola grows, so does my investment. With careful investing, the 7 percent figure is a solid average across years.
I’m sure you’ve heard people worry about the future of Social Security and say that our generation will never be able to retire. I don’t believe that, but we may only get to retire if we plan carefully now. Compound interest means that it’s far better to start saving now than to wait until later on, when earnings are higher and careers are stabilized. Setting a few acorns aside now will help us grow sturdy trees when we need them.
Mathew Carrick is an Economics major, Math minor, and personal finance enthusiast. If you have questions regarding personal finance or financial literacy, feel free to email him at email@example.com for an answer – it may even turn into a column article!