If you are in your early 20s and just starting your career, you might not be too concerned about retirement. It is still decades away, so it might seem that there is no need to worry about it just yet. Even though it might be the farthest thing from your mind, once you understand how compounding works, you might be motivated to get your account started.
Start in Early 20s and Reach Your Goals Sooner
Early adulthood is a busy time. You are just beginning to establish yourself in your career. It might be a time to begin a family or do some traveling. All these things are good, and you can still do them, but it is also time to start spending some time planning for your future. The sooner you start saving for retirement, the sooner you will reach your goals.
The principle of interest and compounding means that you can have quite a nest egg built up in a short time. Life is full of surprises, and having a little put back for emergencies can help you navigate the rough spots without jeopardizing your future. Also, if you start now, you might find that you can retire early, which means that you will be able to start living your retirement dream sooner than most.
Simple Interest vs Compound Interest
The first thing you need to understand is the difference between simple and compound interest. Simple interest just takes into account the initial investment amount, otherwise known as the principle, and any other contributions you make. In this scenario, you might keep the principle and subsequent contributions in the bank to earn interest, but you might spend any interest earned.
Your money will grow if you use simple interest, but the real magic happens with compound interest. When you use compound interest, you allow any interest you earn to roll over and be used as the basis for calculating the interest earned in the future. The interest adds up over time, and any future contributions add up, too.
How Much Can You Save?
The best part is that compound interest has a snowball effect where the interest earned is bigger, and it compounds faster. The best way to compare the effect of simple versus compound interest is to use this simple interest calculator and this compound interest calculator to compare the results.
Let’s say you have saved $1,000 cash and want to put it in a five-year CD that earns around 3% interest. If you put it in a simple interest CD, you will have $2,800 at the end of five years and a net profit of $1,800. If you invested that same amount and allowed the interest to compound monthly, you would have $1,161 in five years and a net profit of $161.
This does not sound like the best idea in this case, but now, let’s change the compounding rate to weekly and say you are going to put in an extra $100 per month. Now, you will have $7,627 in five years and a net profit of $627. If you extend that out to 30 years, you will now have $60,731.
If you invested this initial $1,000 in the stock market, which averages around a 7% return, in an account with weekly compounding, you would then have $130,114 in retirement savings. Most simple interest accounts do not compound more than annually or monthly. If you use simple interest at the same 7% rate and take profits on the interest from stocks, you will only have $26,200 at the end of 30 years. That is quite a difference and can mean living the lifestyle you want if you use compound interest.
Playing with Fire
If you have been around the world of investing for some time, you might have heard of the FIRE movement. It stands for Financial Independence Retire Early. Many young people have jumped on this movement and are well on their way to achieving their dreams of early retirement. Compound interest is the tool they use to build wealth quickly and achieve their dreams.
The next question you might ask is where to invest your money to get the magic of compounding started. Right now, most savings accounts are around 1.5%, but mutual funds are around 7%. Most CDs are around 2-3%. Of course, before you decide on an investment instrument, make sure to check any fees that might apply. Also, many times, a higher interest rate means greater risk.
Achieving FIRE is one reason to begin your savings journey early. Even if you do not achieve FIRE and be able to retire early, you will have much more financial freedom at an early age. If you are in your 20s, the time to start is now, but even if you missed that window, you would be better off if you start now rather than holding off until later.
The Perfect Time to Start Is Now
Now, you can see what a difference finding an account that has compound interest rather than simple interest can make. In this scenario, it assumed a $100 additional contribution per month. That is only $25 per week. You can see what would happen if you skipped eating out one meal a week or one pizza a week and put it into a compound interest account instead.
One of the most common mistakes that people in their twenties make is putting off starting their retirement savings. You might think that you have plenty of time, and there will always be time to get started and catch up later. The biggest regret among people who are ready to retire is that they did not start soon enough.
As you can see from these calculators, if you start early, it will be much easier to reach your retirement goals than if you wait. Every year that passes means that you will have to work harder to reach your goals. These calculators give you the best reason to start looking for accounts so you can reach your goals sooner. If you start now, only a small change in how you spend can make a big difference in the future.