Compound Interest

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Age Year Beginning Savings Contributions Interest/Return Ending Savings

The concept of compound interest is that all interest earned on your initial investment will also earn interest (hence, compounding interest). This is why saving early and investing wisely can create a nice nest egg for retirement.

Example: let’s say you have an initial investment of $10,000 and expect to have a rate of return of 10% annually (compound frequency). After 1 year your $10,000 will be worth $11,000, $10,000 initial investment + $1,000 of interest ($10,000 x 10% = $1,000). After 2 years your investment will be worth $12,100. In year 2 you earn the same $1,000 as year 1 but you also earn an additional $100 because your interest from year one also earned 10% in year 2 ($1,000 x 10% = $100)

Year 1
Initial investment $10,000
1st year 10% interest $1,000
Total investment (year 1) $11,000
Year 2
Initial investment $10,000
2nd year 10% interest $1,000
1st year earned interest $1,000
Year 2 interest on year 1 interest $100
Total investment (year 2) $12,100

Compounding interest is so powerful that if you contribute $458 per month (current yearly ROTH IRA limit) from age 25 to 40 (15 years) and don’t contribute anything afterwards you will have $1,891,973 at age 65 (assuming 10% annual rate of return). If you don’t start saving until age 40 you would have to contribute $1,603.14 per month from age 40 to 65 (25 years) to reach the same amount.

The moral is, start saving as early as possible.