How are you feeling about your retirement prospects these days? Maybe you’re in America reading this and already investing in a 401(k) or IRA or in the UK and have already invested in a Stocks & Shares ISA or a Lifetime ISA and you are already feeling hopeful about the day working will become optional for you. Congrats if you’re on that road!
But if the subject of retirement gets you anxious, you’re not alone. Fifty-six percent of U.K citizens lose sleep thinking about retirement. (1) When planning for retirement, people stress about different things: running out of time to save, making their dream retirement possible, or understanding intimidating numbers and interest rates.
No matter the reason for the dread, there’s something everyone needs to know. You have access to a powerful mathematical tool that can make all the difference in allowing you to retire with dignity: compound interest. Let’s explore what you need to know about this critical factor in almost every successful retirement.
What Is Compound Interest?
Compound interest is a marvellous force behind many of the world’s great fortunes. Do you know someone who came from humble beginnings financially, who used a combination of hard work, patience and wise investment to become wealthy today? Chances are they took advantage of compound interest to get there!
The key to understanding how compound interest works is to realise the role of time. The earlier you push the compound interest button, the more impressive the long-term results.
How Does Compound Interest Work?
The easiest way to see the wonder of compound interest at work is to imagine two friends of the same age who have different approaches to retirement.
Jen and Amber grew up as next-door neighbours and the closest of friends. As our story begins, these two young women are starting their careers at the age of 24. Each is fortunate enough to be offered a 401(k) employee benefit. And they both know retirement investing matters. Despite all they have in common, Jen and Amber never get around to discussing what the other is doing about retirement. Watch what happens next.
- Jen looks into the 401(k) benefit and immediately realises it’s worth her while to invest in. Right away she starts putting in $3,000 a year toward his retirement. Then on her 35th birthday, she sees how much her account has grown and decides she’s never putting in another dime. At that point she’s invested $33,000 of her own earnings in 11 years.
- Amber doesn’t feel as comfortable investing that early in her career. But when she turns 35, she’s a married homeowner and the idea of starting to invest is making more sense to her. She figures she can afford to send about $3,000 a year of her salary to the company 401(k). And she’s so dedicated that she keeps it up for 31 years, all the way to age 65.
Now the two lifelong friends are 65 and ready to enjoy their golden years. The good news is, after all their years of hard work and investing, they’re both in pretty good shape financially. But who do you think wound up with a bigger nest egg? Let’s run the numbers at 10%.
It might sound incredible, but despite Amber investing about triple the money that Jen did, Amber ended up retiring with only about half what her friend was able to save. How in the world can we explain the massive difference? Compound interest.
In both cases, Jen and Amber were investing in growth stock mutual funds and enjoyed the market average growth over the course of their investing lives. But Jen took advantage of an extra ingredient—time! Because of the compounding effect of interest on her account over time, her money eventually took on a life of its own.
Why It’s Never Too Late (or Too Early) to Begin
As anyone can see from the story of Jen and Amber, compound interest is a force you want on your side in the quest to retire well. If the numbers above don’t convince you of the need to let time work for you, we don’t know what will.
But here’s some encouragement in case you’re where Amber was when she started investing. Maybe you’re in your 30s, 40s or even 50s and you haven’t begun saving yet. That’s no reason to throw your hands up and declare retirement an impossible dream. The truth is, you can also leverage the power of heavy-duty savings starting today.
How likely is a hefty savings rate to have a sizeable impact on your retirement? Let’s look at another example. If you’re 40 years old today with no savings, finishing up a millionaire is still within your reach. Depending on how your account grows, the math shows you’d need to put in somewhere between $600–800 a month to make it happen.
One thing to keep in mind before you start putting the power of compound interest to work for you (and this holds true at any age): You don’t want to start investing in retirement unless you’re completely debt-free. All too often people sock away a nice retirement nest egg without eliminating debt during their careers. As a result, they retire deeply in debt and end up spending much or all of their retirement savings to pay it off. If you currently have any non-mortgage debt, it’s best to pause retirement savings until you’re debt-free.
Compound interest is truly a wonder. Imagine how Jen must have felt the day her retirement account turned that million-dollar corner at age 64. Despite putting zero money toward it for over 30 years, it kept on growing for decades. Amber also experienced tremendous growth, but her success relied far more on his savings rate than on compound interest because of his later start. In both cases, compound interest took a retirement dream and turned it into a reality.