We’ve all heard it time and time again. We should start saving as much as we can, as early as we can. But as an excited young professional earning their first paycheck, it’s easy to lose sight of the importance of putting some of that paycheck in an account you won’t use for 40-ish years. As a 23-year-old in my first real job, I was tempted to contribute just a minimal amount to my retirement fund every month. After all, every dollar I contribute, is one less dollar I can spend today on things that are far more fun than a 401k. Plus, I’ve got the rest of my life to save, right? This thought process is so common among young professionals who don’t fully understand the value of compound interest.
What is Compound Interest?
Compound interest… (hopefully) we’ve all heard that term, but do we truly understand what it means? Humor me while I lay out a simple example:
Let’s say I have a really creative, glamorous, job at Google out of college. Google sets up a retirement account for me, and I decide to save $100 from my paycheck and move it into this account. Let’s assume that my $100 will earn 5% in interest at the end of each year and after year 1, the balance in my account should be $105.
…a whole year and I only earned $5?
Patience. In year 2, I earn another 5%. But this time, I earn it on $105 instead of $100. So at the end of year 2, I have $110.25. In year 3, I earn another 5%, but now on $110.25. I could keep going, but I think you get the point. Each year, the interest compounds, meaning I earn interest on interest. Let’s fast forward 40 years. I’m now 62 years old and kinda, sorta, maybe thinking about retiring soon because I’m now I worked my way up the ladder and just want to spend my time sipping on tequila in Aruba. I check my account, and after 40 years, my balance is over $700. And all I had to do was save $100, one time.
That was a very simple example, but think about the magnitude if I were to save $100 per month for 40 years. Using the same logic, my savings would be worth nearly $12,800. Also, most employers will match your retirement contributions up to a certain amount. In other words, for each month that I’m saving $100, Google will contribute an extra $100. So…if you can afford to set aside a few dollars now, there is no reason not to take advantage of free money.
The Bottom Line
The main takeaway is this: saving early does make a difference. Compound interest is powerful, and the longer you can let it work for you, the better.