Savings

# Compound Interest: When Less is More

Did you know that you can invest less money, but still end up with more money saved for retirement? Because interest is compounding, money you invest grows larger the longer it is invested.

Compounding interest means that your interest is earning interest. That means that if you invest \$100 at 8% interest rate, after year one you have \$108, but the next year you would have \$116.84. That is because the 8\$ you made in the first year gains 8% interest in year two for an additional gain of \$0.64. Over time this adds up to a lot of money!

This chart shows \$100 growing at 8% annually over 30 years. Compound interest means that the 8% interest rate keeps growing off the interest you earned in all the years prior.  By year 10, your \$100 is worth \$215.89!  With simple interest however, you gain \$8 per year every year and in year 10 you have \$180.

Compound interest is the reason why you can invest less money earlier, and get huge gains in the long term.

Take the example of Chloe and Zack.  Chloe invests \$2,000 each year from age 20 to 30, so she invests \$22,000 in her lifetime.  Zack invests \$5,000 each year from age 35 to 49, for a total of \$75,000.  Zack is investing more money, but Chloe has her money invested for a longer amount of time.  Here’s how their worth compares:

Although Chloe invests \$22,000 dollars total, while Zack invests \$75,000, she still ends up with slightly more money.  That is because Chloe’s investment had more time to benefit from the compounding interest. (Interest rate here is 8%.)  Had Zack invested 5,000 for a couple extra years, or started investing a few years earlier, he could have caught up with Chloe, but at a much higher cost.

Not everyone is capable of beginning to invest as early as 20, but everyone should be aware of the benefits of compounding interest.  Retirement is not about being rich if you start early.

Categories: Savings