Compound Interest

Compound Interest

“Compound interest is the eighth wonder of the world.
He who understands it, earns it …
He who doesn’t … pays it.”

– Albert Einstein

If you have been to a retirement seminar or taken a financial class, you have probably heard the term compound interest. Why? This magical concept, when properly employed, can help you accumulate a lot of money. Instead of boring you with the Time Value of Money (TVM) equation, I want everyone to focus on one powerful variable of the equation, TIME.

Time is represented, in most cases, by the letter “n” in a future value calculation. The “n” stands for “number of periods” or for the sake of this explanation, how many years you plan on letting the money sit before you start taking withdrawals. But…… what is a future value? This result will tell you how much your current lump-sum of money will be worth in the future assuming a specific average rate of return, as well as how long you plan to let the money sit for.

Let’s get back to time though. Why is it so important? Time is what makes the biggest difference in the equation. Glance at the equation again; you will notice that “n” represents the exponent in the equation. When I hear the word exponent, my financial mind immediately thinks about exponential growth (think 5x5x5x5=625). This type of growth does not make a linear diagonal line; It makes that flattened out J-shaped graph that we all loved learning about in school.

The point I am trying to make is that it is important to start saving for your future as soon as possible because time is the exponent in the equation! Yes, when we are younger it is harder to save because of a plethora of reasons (student loans, saving for a home, getting married, etc.) but don’t let procrastination be one of them. It could cost you valuable years during the longest vacation of your life, retirement.

Another essential component to making this concept a reality is tax-deferred growth. Saving in your taxable brokerage account will not allow you to utilize compound interest because of the taxes you must pay every time you sell a position for a gain. So, make sure you are using smart tax wrappers like 401ks, 403bs, IRAs, Roth IRAs, etc. If you have any questions or would like to chat, contact me.