Compound interest… we’ve all heard that term, but do we truly understand what it means? Humor me while I lay out a simple example:
Let’s say I have a really creative, glamorous, job at Vogue out of college (haha, keep dreaming Erica #leftbrain). Vogue sets up a retirement account for me, and I decide to save $100 from my paycheck and move it into this account. Let’s assume that my $100 will earn 5% in interest at the end of each year. After year 1, the balance in my account should be $105, right?
Geez…a whole year and I only earned $5?
Patience! In year 2, I earn another 5%. But this time, I earn it on $105 instead of $100. So at the end of year 2, I have $110.25. In year 3, I earn another 5%, but on $110.25. I could keep going, but I think you get the point. Each year, the interest compounds, meaning I earn interest on interest. Let’s fast forward 40 years. I’m now 62 years old and kinda, sorta, maybe thinking about retiring soon because I’m the Editor in Chief and just want to spend my time sipping on margaritas in Mexico. I check my account, and after 40 years, my balance is over $700. And all I had to do was save $100, one time.
That was a simple example of pretty low magnitude, but think about this scenario. If I start a habit of saving $500 per month into an account earning 5% interest, my balance will be over $200,000 in 20 years. In 30 years, it’s over $400,000. Fast forward 50 years, and it’s $1.3 million! Compound interest literally turns time into money.
Additionally, most employers will match your retirement contributions up to a certain amount. So, if you can afford to set aside a few dollars now, there is no reason not to take advantage of free money.