Understand And Use Compound Interest To Your Advantage
Photo by Josh Felise / Unsplash

Understand And Use Compound Interest To Your Advantage

OMG! Retirement!

Just like the redwood trees took time to grow into the giants they we know today, growing your money also takes time and patience. Redwoods didn't grow to be the tallest trees on earth overnight, it happened over time because they found the right environment for growth.

Unlike the redwoods, we don't have hundreds of years to grow our money into something that could be relied upon for retirement. In most cases, about 30 years is the average life of a working adult's career. 30 years seems like a really long time, but if you waste even 5 of valuable investment years, it could mean a substantial loss of potential growth due to how compound interest works. You don't have to be an expert at understanding compound interest. Just know that you want to earn it but not pay it.

Compound interest is the 8th wonder of the world. Those who understand it earn it, those who don't, pay it. - Albert Einstein.

Einstein is one of the greatest minds ever existed. So if he said what he said about compound interest, it must be incredibly valuable. For the geeks out there, we can calculate compound interest using the following formula:

A = P(1 + r/n)nt

A = Accrued amount (principal + interest)
P = Principal amount
r = Annual nominal interest rate as a decimal
n = number of compounding periods per unit of time
t = time in decimal years; e.g., 6 months is calculated as 0.5 years. Divide your partial year number of months by 12 to get the decimal years.

If that hurts your brain, don't worry, calculators exist to make this super easy.

Power of compound interest

Let's now see how this powerful compound interest can work wonders for your retirement savings. Imagine you are in your 20s and saved up $1000 towards your retirement nest egg. If you invest that $1000 into an investment that produces an average return of 8%, which is totally doable over 30+ years, and you deposit $500 every two weeks, you might have over $1 million at retirement. All it takes is discipline and patience. Once you master the art of paying your future self first, no matter what, you should be able to save and grow enough money for retirement. This way you don't count on social security, which may or may not be there for us in 30 years or even 20 years. Take matters into your own hands. Only you're responsible for your future, no one else.

Compound interest calculator from mint.com

Notice that in the above screenshot you contribute $391,000 over the 30 years, but your total return after 30 years is $1,147,632. This is the power of compound interest. That said, no return can be guaranteed and all investments contain risk of losing money, but you're rewarded for taking the risk if all works out in your favor. How do you make sure your money is safe or safer? You really should consult a Fiduciary advisor that has your best compound interest (pun intended) at heart. A fiduciary financial advisor can help you pick the right long-term investments that go the distance and use the power of compound interest. You can also do this yourself by researching ETFs that provide diversity in your exposure to the stock market, such as VTI or SWTSX. Whatever investment you end up choosing, just make sure you understand the risks and the "expense ratios" associated with each of your investment choices. For example, the ETFs above have super low expense ration of 0.03%, which means it will cost you $30 per year for every $10,000 that you invested, which is probably the lowest cost you can find.

Good luck and now go earn that compound interest.