Part III in my on-going series about retirement accounts.
I hate math. I’m not talking about a vague dislike of x+y = z, we’re dealing with full-unadulterated hatred. Frankly, I blame second grade. My teacher, Ms. Pruitt, insisted we memorize our multiplication tables from 0 through 12. She even made us flash cards to aid the process. As an epic memorizer, I felt confident this task would be easy, but for some reason numbers made my brain want to shut down. Even at seven. Needless to say, there may have been a moment when I dramatically crumpled up a flash card and threw it on the ground in a math-induced-rage.
As my schooling progressed, math continued to be the bane of my existence. Well, I could still pull a B in the course, but I hated every second of it. As the years went by and the theories (theorems? proofs?) became more abstract or just plain dumb, in my very biased opinion. Instead of trying to understand the pages of numbers or even worse, word problems, my mind would just go on a casual stroll. Only one chapter of math briefly taught during my high school education made complete sense: finances.
I’m not sure if the typical American math curriculum includes a chapter on finances (I spent 5th – 12th grade overseas), but it seems a lot of millennials don’t understand the concept of compound interest. If you don’t understand compound interest then you’ll never get excited about saving and investing your money. Millennials need to grasp the basic fact it isn’t your salary making you rich, it’s your abilities to save your income and invest it wisely.
Every year, month and day matters when it comes to amassing your wealth and preparing for retirement, which is why it’s imperative millennials understand the importance of starting now.
I refer you to this example from JD Roth over at Get Rich Slowly:
If 20-year-old Britney makes a one-time $5,000 contribution to her Roth IRA and earns an average 8% annual return, and if she never touches the money, that $5,000 will grow to $160,000 by the time she retires at age 65. But if she waits until she’s [author's] age (39) to make her single investment, that $5,000 would only grow to $40,000. Time is the primary ingredient to the magic that is compounding.
Sounds great (or scary), right? But you might be wondering exactly what is compound interest?
(I get really excited about makin’ it rain. Even with Monopoly money.)
First let’s start with interest or “simple interest.” Interest can work for you or against you. In the simplest form, interest is a fee being paid by a borrower to a lender. If you put your money in the bank, the bank is then using your money (nope, it doesn’t just sit there in a vault) and paying you a small percentage to do so. Or if you borrow money, hello student loans, then you’ll owe the initial amount of your loan plus the interest you’ve accrued in the years it has taken for you to pay it off. Simple interest is only paid on the initial principal. Stay with me now, it’s about to get exciting!
Compound interest is proof of the proverb money begets money. With compound interest, your money will earn interest on the interest already accumulated. Let’s break it down.
You invest $4,000 using simple interest for 2 years with an interest rate of 8%. At the end of the first year you’ll have earned $4,320. At the end of the second year you’ll see $4,640 in your account.
Now, take the same investment and use compound interest. The first year, you’ll earn the same amount you would using simple interest, $4,000 x 8% = 320. However, in the second year instead of just accruing interest on the original $4,000 you’ll get to use $4,320. The formula will then be $4,320 x 8% instead of $4,000 x 8%. At the end of your second year you’ll have amassed $4,665. Doesn’t sound like much now, but what if we expand the example to five years?
With simple interest you can use a quick, one-time formula: $4,000 x .08 x 5 = $1,600. You’ll have a total of $5,600.
For compound interest, I’ll show you the growth each year. We already know you’ll have $4,665 by the end of your second year, so let’s compound it for the next three.
Year 3: $4665 x .08 = 373.2 [5,038.2]
Year 4: $5,038.2 x .08 = 403.1 [5441.26]
Year 5: $5,441.26 x .08 = 435.3 [$5876.56]
You were investing the same principle amount and over the same period of time, but with compound interest earned $276.56 more than you would using simple interest. There is even a simple way to quickly discover the length of time until your money doubles, the rule of 72. Using this dreaded math theory (theorem? proof?) you simply divide 72 by your interest rate. In our example above it would take 9 years to double the principle investment.
My point? Make sure you’re taking advantage of compound interest. Namely, open up a Roth IRA and/or make sure to take advantage of your company’s 401(k). The longer you procrastinate the more money you’re throwing away. I mentioned last week too many of my peers keep making excuses about deferring planning for retirement. Don’t make excuses and just figure out how to make it work. You won’t regret it.
Even the Wall Street Journal agrees: It’s Never Too Soon to Start Planning Your Retirement.
Oh, and Albert Einstein.