Compound interest is great, but there's a catch
The return on investment from a compound interest savings account isn't impressive at first, but if you stick with it, it becomes a locomotive. But it can take a very long time.
One of the first topics covered in almost any personal finance book you read is the power of compound interest.
Compound Interest 101
You can skip this section if you’re already familiar with compound interest and how it works. I’m including it for people new to the idea.
Let’s say you have access to a savings account that pays 5% interest. You decide to put $1,000 and let it sit for future emergencies. For easy math, we’ll say it compounds annually (meaning you only figure up the interest on it once a year).
At the end of the first year, that account has $1,050 in it. You have your original $1,000, plus you have 5% interest on it – $50.
At the end of the second year, the account now has $1,102.50 in it. You have the $1,050 you had in it after the first year, but this year it earned more interest – $52.50. Why? The interest earned during the first year is now itself earning interest. You didn’t just earn interest on the first $1,000. You also earned it on the $50 in interest from the first year – an extra $2.50.
At the end of the third year, the account now has $1,157.63 in it. You have the $1,102.50 from the end of the second year, but this year it earned $55.13 in interest.
Now, from the first year to the second year, your interest grew from $50 to $52.50 – an increase of $2.50. From the second year to the third year, your interest actually grew even more – jumping from $52.50 to $55.13 is a $2.63 increase in interest. Not only is the amount of interest growing from year to year, the amount that it grows each year is actually increasing.
At the five year mark, you’d have $1,276.28 in the account.
At the ten year mark, you’d have $1,628.90 in the account.
At the twenty year mark, you’d have $2,653.30 in the account. Your money has more than doubled without you lifting a finger, and every single year, the money has grown more than it did the year before.
That’s the power of compound interest. It’s not impressive at first, but if you stick with it, it becomes a locomotive.
Compound Interest Is Great, But There’s a Catch
What’s the catch? In order to really enjoy the power of compound interest, you have to let your money sit for a long time.
In the example above, your money has doubled at around the fourteen year mark. Sure, it’s awesome that your money has doubled, but it took fourteen years for it to do so. That’s a long time. Think about where your life was fourteen years ago.
I was a college sophomore. I was dating the woman I would eventually marry. I had only met one of the large handful of people who would help me build my first career. My life was completely different.
The seeds of a success today were planted in that completely different life.
If you really want your money to have an impact on your life, you shouldn’t start with the investments.
The first thing you should do when you have some money to set aside for the future is to assess your goals. What do you want out of your life? What are your dreams? Your hopes for the future?
If things were to fall reasonably well, where would you really like your life to be next year? In five years? Ten years? Twenty years? When you’re 65? Those are the questions that should underline how you handle much of your money (outside of your basic bills).
Sure, we do spend some of our money for today, but spending all of your money for today means that you’re ensuring your tomorrow won’t be much better than today.
So, how do you most effectively turn that little bit of extra money today into the better life that you want tomorrow? There are lots of ways to do that – and they aren’t all found on the pages of a financial magazine.
Do you want a better – or at least different – career? The best way to get there is through education, and the best way to prepare for that is by putting your money into a 529 college savings plan for yourself for a few years, then making that leap.
What if you want something that doesn’t seem as directly related to finances, such as better physical fitness? That requires an investment of time and energy, not so much finances. Those are investments, too.
What if you want freedom from debt so that you don’t have the monthly bill stress and your boss doesn’t have as much power over you? That requires an investment, but it’s in the form of living lean and making extra debt payments.
In each case, the first little step you make doesn’t make a big difference. One day of exercise does not change your fitness level. One extra debt payment doesn’t rock your debt situation. A small amount in a 529 does not alone make for a new career.
Much like with compound interest, it’s the continuous steps that begin to build on themselves. Exercise several times a week and it becomes easier and more rewarding. Make an extra debt payment every month and the debt begins to melt faster and faster. Regular money in a 529 starts to build on itself, turning a dream of a new career into reality.
You can build the life you want. You just have to figure out what you want, then take steps every day to make that life happen, whether it’s a money step, an energy step, a time commitment step, or something else. The more steps you take, the easier they become and the more your efforts begin to reap rewards beyond what you expected.
Almost every success you have in life is an investment. Almost every success in life builds on the little steps you’ve put into it, growing beyond what you ever expected from them. A dollar in savings every day, a half hour practicing a skill every day, an energy-burning workout every day.
It all starts with the commitment to take those little steps and see a very small reward from those steps at first. Do it over and over again and those successes begin to compound. Stick with it and that investment begins to pay off in ways that change your life.
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