Two Words: Compound Interest
Definition: Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. In other words, you earn interest on interest. Albert Einstein said it this way, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.”
When you were growing up how many times did you hear, “What do you think, money grows on trees or something?” Well I’m here to tell you, “yes, it does!” Well, kind of. Similar to how a tree produces fruit and leaves, money produces dividends and interest. If you choose to reinvest the dividends and interest, not only do you continue to earn interest on your original investment, but you also earn interest on the interest from the previous year. The more time you have on your side, the more powerful this concept becomes, which is why you should invest sooner than later. When this interesting phenomenon occurs, we call it compound interest.
Like most things, I think the best way to understand compound interest, is to picture it. Below is a great visual representation from finance guru, Dave Ramsey, of what this looks like:
You might be saying to yourself, “okay, okay, I get it, but how do I start, where do I go, should I invest in my company’s 401(k), what about a Roth IRA?” Whoa, whoa, slooooowwwww down. I know it can be overwhelming, especially with the internet these days, but it doesn’t have to be.
3 Easy Ways to Get Your Money Working For You
- Brokerage Account – With a brokerage account you can invest in all kinds of vehicles like stocks, bonds, mutual funds, exchange traded funds, real estate, etc. You can create and Auto Investment Program to invest a specific amount each month out of your bank account. Keep in mind a brokerage account is not a tax-deferred vehicle like your 401(k) or IRA, therefore you will pay taxes on what you earn each year, minimizing the benefits of compound interest. However, it could be a great tool for shorter term goals like purchasing a home or saving for a wedding.
- Employer Sponsored Retirement Plans (ie: 401(k) Plan) – If your company offers you a retirement program like a 401(k), take advantage of this benefit. If they offer you a matching contribution, you would be foolish not to take advantage of this benefit as it’s not offered by many employer’s nowadays. This is free money people! It’s easy too. You should have received an enrollment packet, typically from your HR Department. All you have to do is sign-up, select how much you would like to contribute (ie: 5%), and they start deducting this from your paycheck. The beauty of this is you never even see the money and it’s all handled automatically. There could also be some tax advantages in doing so, but you’ll want to take that up with the person who handles your taxes. Confused about where to invest the money once you have this set up? Consider the Target Date Funds that are typically offered as an investment option.
- Roth IRA – One of my favorite vehicles. Without going into too much detail about what a Roth IRA is and how it works, if you are a young investor looking to save for retirement (and in some cases your children’s college fund), this should be one of your first stops on your journey. You won’t get a tax deduction today, but you can potentially build a huge nest egg that’s tax-free when you retire. In some cases your employer may offer you a Roth 401(k) too which is definitely something to consider. A Roth IRA (or Traditional IRA for that matter), like the Brokerage Account above, gives you the ability to invest in all types of investment vehicles. You could also set up an Auto Investment Program, but keep in mind there are specific IRS limitations based on your income and tax status. So again, consult with your tax and financial professionals to see if a Roth IRA might be a good fit for you.
“But I Live Paycheck to Paycheck”
Are you not convinced yet? This is one of the biggest excuses I hear from people. As much as you probably don’t want to hear it, you have to budget. I can’t tell you how many times someone has sat in my office telling me they don’t have enough money to invest. In every instance, once we start looking at past spending habits, we always find somewhere you can squeeze out at least $50 per month. Sometimes it’s just a simple call to your cell phone or cable provider to see if they can lower you bill. Be creative and make the necessary sacrifices today to get what you want later in life. I know you know this, but I also know it’s hard because we’re always trying to keep up. Keep up with our friends, our family, our coworkers. Remember, what you see is NOT what you get. A lot of those people you’re thinking about probably don’t have a plan, aren’t saving towards and emergency fund, aren’t contributing to their 401(k)’s, but at the same time they’re driving BMWs, Audi’s, Range Rovers, etc.
As Thomas Jefferson once said, “Do not bite at the bait of pleasure till you know there is no hook beneath it.” Ask yourself again, would you rather be Ben or Arthur? The bottom line is you have to make it a priority and you have to be disciplined. In all areas of life discipline is painful at first, but the fruit of discipline can have huge pay-offs. So next time someone tells you money doesn’t grow on trees, you can tell them it depends on how you look it. Anyway, money IS made from trees isn’t it?