The Ultimate Motivator: Compounding Interest

“INTEREST ON YOUR INTEREST”

This post is for anyone who is hesitant to start contributing to your retirement savings and why the sooner you start the better of you will be.

Many young people in their 20s and even 30s are hesitant to start contributing to their 401K or other retirement account, especially due to the latest economic collapse.  How do I know?  I spent close to two hours trying to convince a few coworkers to start doing so, with only one seeing the light.  Their reasoning:  “That is so far away, I would rather use the money to pay down student loans, buy this new car, I can just save later”, and so on.  Valid points, I too have lots of debt, would like a new car, oh and I’d love to leave tomorrow for a month long vacation in Hawaii, but that’s just not practical.  If I stopped my contribution, I could DEFINITELY use the extra cash that I would save not contributing to my 401(k) right now!  BUT, I have a much better idea, I’ll give up a little extra now to ensure a much more secure retirement down the road.

This post is just to speak on the incredible power of compounding interest, leaving other important parts of retirement savings such as tax advantages, employer contributions, and so on, out of the picture for now.  Why?  Because with all retirement savings, the majority of total accumulated cash will be a result of compounding interest, NOT your contributions.  That being said, let’s take a quick look as to WHY compounding interest should be the BIGGEST motivator for you to start contributing NOW to your retirement savings… yes, even if your 23.

Over the lifetime of your retirement savings, the majority of your contributions per year will either come from personal contributions or compounding interest, it all depends on what period of time we are looking at.  Most of your retirement savings growth will result from your contributions for the first half of your life, while interest will account for the latter part, as well as the majority of your total funds.  The sooner you reach the point in your life where interest accounts for more total contributions to your retirement savings than your total annual contributions the better.

The point of all this is that during a certain point, the amount of money that you generate through interest on your savings will surpass the amount that you contribute each year.  For example, in my first year of savings, if I contribute 10% of my $100,000 per year salary, or $10,000, towards my 401(k), and I get a 6% return, my total contribution for the year will be $10,600 ($10,000 at 6% is $600).  $10,000>$600, therefore the majority of my 401(k) growth was due to my personal contributions.

Fast forward 10 years (keep in mind these are all very SIMPLE numbers just to get the point across) and I have $200,000 in my retirement savings.  For simplicities sake, let’s assume I still make $100,000 and am contributing 10% of my income towards retirement.  $10,000 (10% of my income) + $12,000 (6% Interest on $200,000) = $22,000.  $12,000>$10,000 therefore the majority of my 401(k) growth was due to interest.

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I could go on and on about this awesome subject, but I am making the effort to shorten the length of my posts.  The point of all this: If you are not contributing to your retirement savings, START!

  • The sooner you start contributing to your retirement savings, the better.
  • The quicker you reach the point in your life where compounding interest surpasses your personal contributions, the better.
  • The longer compounding interest is working at its full potential, the greater your rate of return will be.
  • The total amount of compounding interest in your retirement account will greatly surpass the total amount of personal contributions in your retirement account.  So PLEASE get started!

Keep in mind this was a VERY simple example on the power of compound interest.  Here is a great link to another example as to how compounding interest can really add up.  In this example, it’s a difference of $62,000!  (Also keep in mind in this example they are working with a 12% rate of return, so obviously this is not too relevant for today, but the point stands).

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March 10, 2010 · myfinancialobjective · 7 Comments
Tags: , , , ,  Â· Posted in: Retirement

7 Responses

  1. FinEngr - March 12, 2010

    MFO:

    The magic of compounding…

    It’s not only important to contribute enough, but to contribute now. The earning interest on interest is what balloons accounts.

    Historically, roughly 50% of stock returns were due to dividends (various sources)

  2. Rannie - March 12, 2010

    MFO! Great post…! Makes me want to start saving now!

  3. myfinancialobjective - March 13, 2010

    FinEngr, “interest on your interest”, you gotta love it!

    I just had a long discussion with a friend about dividend stocks recently, due in part to the PF bloggers!

    Rannie, Good! Start! hehe :)

  4. Financial Samurai - March 13, 2010

    Wish I could get 6%! Alas, the best interest I can get is 4% on my 5-7 yr term CDs.. That said, better than a slap in the face yeah?

    I’m saving like a banshee. 50% of my income or bust! I’d like to see if I can retire from my day job in 10 yrs….

  5. myfinancialobjective - March 13, 2010

    Wow that’s a seriously ambitious plan, I hope you achieve it! I have a similar plan: retire before 50, even if its 49 and 364 days old.

    I chose 6% because two of the most recent books I read used either 5% or 7% I believe as average returns for retirement accounts (I’d have to go back and double check, but I returned them already). I chose 6% because it’s not the highest, or lowest.

    Thanks for the comment Fin Sam!

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