When you are just settling into your career, the last thing on your mind is planning for retirement. Something a little more pressing on the brain will be things like paying off your student loans, saving up for a house or new car, things that will benefit you right now and well into the future. So why stress about your financial future when you have all these other smart financial choices that will benefit you in the long run as well? Well here is the secret to it all; compounding interest. Most retirement accounts will have compounding interest. Here we will give you all the details of how it works, why it’s important, and how it will benefit you long term. Let’s find out how.
What is compounding interest?
Put simply, compounding interest is when you earn interest on the money you put into an account along with interest previously earned. So the money you contribute along with the interest earned will become your new principal amount and then that new amount will gain interest again. Compound interest is exactly like a snowball effect. Imagine if you contributed a small amount of money each month into your retirement account that utilizes compounding interest how fast it would grow.
How does it work?
Here’s an example to better show how it works. Say you put $1,000 into your account and earned 10% interest annually. By the end of the year your new balance would be $1,100 meaning you earned $100 in interest from your initial $1,000 contribution. You will earn interest at the same 10% rate on your new balance of $1,100 so the following year your balance would be $1,210. Here you can see that instead of only applying the interest to the principal you have contributed, compounding interest applies to the principal you put in, plus any previous interest earned. It’s important to point out that in the example given we did not add any principle. That new amount of money is solely compounding interest.
How will it benefit me?
The benefit is very plain to see. Basically you get free money as long as you keep it in the account so it can keep growing. Your money will grow even more the more principal you put in and the longer you keep it in the account. Using that same example of $1,000 principle amount with a 10% interest rate after one year you would have $1,100. After 5 years it would turn into $1,611 and after 10 years it would be $2,594.
Planning for your financial future can be hard to do in the moment, especially when you have a lot of other financial goals you want to hit. The most common place to see compounding interest applied are in retirement accounts. If you start making small contributions to an account that utilizes compounding interest you will be able to retire sooner and with more money than a typical savings account can offer. Don’t overwhelm yourself. Make and frequently update your financial goals and be sure to keep retirement in mind while planning for your financial future.