Albert Einstein once described compound interest as the “eighth wonder of the world”, saying: “he who understands it, wins it; the one who does not, pays it.“
Compound interest is when the interest that one earns on a principal balance is reinvested and generates additional interest. This concept helps accelerate the growth of money like that of a savings account.
If we set aside $ 1,000 in a savings account and earn 8% interest, the ending balance for the first year would be $ 1,080. For the second year, the balance still earns 8% interest, so the second year ending balance would be $ 1,166.4.
Examples of accounts that make up interest are savings accounts and 401 (k) plans. Users of these accounts can expect a substantial increase in their balances over a period of time.
Compound interest can’t just be used to save, but also to invest. For a family of four who receives $ 2,400 in stimulus checks, if they invest the amount in a general stock index, they can expect $ 67,000 in 35 years based on historical average returns.
While the checks are meant to support those facing financial hardship during COVID-19, households with stable income and healthy finances are in an excellent position to take advantage of compound interest.
Unfortunately, compound interest can hurt people with loans, such as tuition fees and on-time credit card payments. If someone is struggling to pay off their debt on time, they may be charged late fees. Then, if no payment is made in the future, their loan interest will be compounded, sometimes at a daily rate.
In addition to possible late fees, the consequences can include a reduced credit score – which could affect one’s future ability to take out loans – and the possibility of losing assets to repay debt.
Nonetheless, BuzzFeed reporter Amber Jamieson described how compound interest is the path to wealth and a financially comfortable future. Speaking from experience, she advises people to start early, not to worry about having a small initial investment, and to maximize the length of time you have money in a market.
“Millionaires are made in their twenties and thirties, not their fifties and sixties,” said Fred Creutzer, president of Creutzer Financial Services, “the early bird always has the worm.”
It may seem difficult to find the money to save for retirement when entering the workforce, but changing your spending habits could be the answer.
For example, reducing coffee purchases could lead to $ 800,000 at retirement. What if, instead of spending $ 5 on a latte each morning, we invested that money and made coffee at home using much cheaper alternatives? With this approach, after 50 years one could save $ 800,000 for retirement just by changing the way you get coffee – just one example of the many expenses people can cut back and invest for retirement instead. .
The education system today seems to be criticized for its lack of financial literacy, as the dissemination of knowledge on the subject is apparently limited. More people should be exposed to compound interest early on, as it makes a big difference in how much money they will have in retirement.
The next time you want to buy those new shoes or buy that designer jacket, you have to think about the decision and how much that money could grow by the time you retire. For people in their 20s and 30s, now is the time to start investing and earning compound interest.
Andrew Withers is a major junior in finance. Contact him at [email protected]