You may have heard a particular bit of financial advice going around social media recently, which goes something along the lines of, “you’re supposed to have saved twice your annual salary by the time you reach age 35.” For many millennials around that age, this advice sounded a little out of touch, if not downright hilarious. Saving isn’t easy when you’re just making enough to keep up with the cost of living, especially if you’ve got student loans or other debts to pay off.
Putting aside the hot takes, the central premise of this advice is nothing to laugh at—the earlier in life you start saving, the better. The good news is that there’s still plenty of time to amass significant savings if you start in your mid-thirties. The key to making the most of your savings, and the reason it’s best to start saving as soon as you can, is compound interest.
Compound vs. Simple Interest
There are two ways to calculate interest on money that has been borrowed or invested, which are simple interest and compound interest. Simple interest is a fixed percentage of the principal amount. In other words, if you invest $1,000 at 5% simple interest, you would receive fifty dollars in interest every year. At the end of five years, your $1,000 investment would be worth $1,250.00.
If you’re saving for your future, it’s much better to invest in a financial instrument that gives you compound interest. Compound interest is calculated not just on the principal amount, but on the accumulated interest as well. This might not make a huge difference in your first few years of investing, but over a longer period of time, compound interest can make your initial investment grow considerably.
How Compound Interest Works
Let’s take that $1,000 initial investment from the simple interest example, and see what happens if we invest it in an account that earns compound interest. The first year, the interest payout is the same—fifty dollars, or 5% of $1,000. Now, at the one-year mark, the account has a balance of $1,050. When the next year’s interest payment is calculated, it’s going to be 5% of $1,050, which means it goes up to $52.50.
The best way to see how compound interest really begins to outpace simple interest earnings over time is to compare the two types of interest-bearing accounts over a thirty-year period:
|Length of Investment||Simple Interest Account Balance||Compound Interest Account Balance|
After thirty years, the simple interest account has increased by $1,500, but the compound interest account has increased by $3,321.94—more than twice as much. That’s pretty impressive growth for a relatively small initial investment, so just think about how much money would be earned on a larger investment that you kept adding to every year.
The Different Compounding Frequencies
Not all compound interest accounts are exactly alike. Compounding doesn’t have to be compounded annually. There are many investment vehicles that compound at more frequent intervals—quarterly, monthly, or daily, to list a few. When it comes to compounding frequency, the shorter the interval, the faster the money grows.
Let’s take that example above and see what the thirty-year balance would be, at different compounding intervals:
It’s not as dramatic as the difference between simple and compound interest, but the benefits of frequent compounding will definitely add up, especially if you’re dealing with larger principal amounts.
Where to Earn Compound Interest
Hopefully, you’re convinced at this point that there’s no better time to start investing than today, and you’re probably wondering where to find a savings or investment account that will pay you that sweet compound interest.
Fortunately, because compound interest is so much more desirable than simple interest, most savings accounts provide compound interest earnings, as do money market accounts and certificates of deposit.
You can also apply the principles of compound interest to investment vehicles that don’t pay interest, like stocks that pay dividends. If you reinvest those dividends in more stock, your earnings will increase each year in the same way that compound interest does, as long as the stock performs well.
When you’ve got significant amounts of money to invest, it’s always a good idea to look for solid, sensible financial advice to help you find the best places to put your money. Even if your finances are tight, and you don’t have a lot of spare cash to invest, just putting a little bit away every month in an account that pays compound interest can pay off in a huge way when you’re older. Do something nice for your future self, and start saving today.