Flickr / Sarah Buckley
Certified financial planner Sophia Bera answers:
Everyone talks about how compound interest is so important and that I should be taking advantage of it with my investments. But what is it? How does it work?
Legend has it that when asked to name the greatest invention in human history, Albert Einstein simply replied "compound interest."
Whether he actually said it or not, I wouldn't disagree.
If you had $1,000 in cash and just hid it in a drawer, it would still be $1,000 — and thanks to inflation, over time that $1,000 would be worth less.
But if you invested it and earned an average return of 7% , in one year you'd be sitting on $1,070. In the next year, you'd earn 7% not just on the original $1,000, but on that $70 in interest, too — which means at the end of year two you'd have $1,145.
The "compounding" comes from the interest you earn on the interest you've already earned.
(Remember that investment returns are unpredictable and never guaranteed, but 7% is often used as an estimation tool based on historical stock market returns.)
If you're keeping most of your cash savings under your mattress (this is a real thing), you're missing out on the amazing benefits of compound interest. It's what allows your money to grow exponentially without much effort on your part!
Here are a few places where you might be able to earn more money on your money:
A high-interest savings account: for any money you'll need for big-ticket items in the next five years, like a house or car — your money is still easy to access if you need it, but not so easy that it's tempting to spend it. I like Ally Bank because you earn 1%, which is about 100 times better than most big banks are paying.
Investments like ETFs or low-cost index funds: for money you don't need for at least five years, you should consider investing it. However, the type of account you want to invest in depends on your time horizon.
Contributing to a 401(k) or an IRA: If you want to set your money aside for retirement, stash your cash in the retirement account available through your employer (401(k), 403(b), SIMPLE IRA, etc.) or open an IRA or a Roth IRA through an online discount brokerage firm like Betterment, Vanguard, or Schwab. You can still invest in low-cost index funds or ETFs — it's just that these accounts have a special tax wrapper around them, so do your research to determine if you want to pay taxes on the money now (Roth IRA, Roth 401(k)) or later (IRA, 401(k), 403(b), SIMPLE IRA).
Let's say you're 25 and you decide to open a Roth IRA and contribute $50 a week for the next 40 years. If your average rate of return is 7%, you'd have over $500,000 when you retire. Since it's in a Roth IRA and the money is taxed when you put it in, it grows tax-free, and when you withdraw it in retirement, you don't have to pay taxes on it.
However, you're an overachiever and you want to contribute the maximum to your Roth IRA every year, which is currently $5,500. You make monthly contributions of about $458, earning 7% interest, and at the end of 40 years your Roth IRA could be worth $1,200,000!
Isn't compound interest the best?
Sophia Bera, CFP® is the Founder of Gen Y Planning and has been quoted in The New York Times, Forbes, Business Insider, AOL, The Wall Street Journal, and Money Magazine. She tweets, travels, and loves helping millennials manage their money more effectively. Curious? Sign up for the free Gen Y Planning Newsletter.
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