Wednesday, May 2, 2007

Power of Compound Interest

One of the most powerful mechanisms in the world in terms of finance is that of compound interest. This is your money making money for you. Most banks pay about 0.3% interest on accounts less than $10,000. Let's say you put $10,000 in a savings account and didn't touch it for 5 years:

Year 1: interest ($10,000 x .003) = $30
Year 2: interest ($10,030 x .003) = $30.09
Year 3: interest ($10,060.09 x .003) = $30.18
Year 4: interest ($10,090.27 x .003) = $30.27
year 5: interest ($10,120.54 x .003) = $30.36
Total = $10,150.90

You earned a return on your money, but it was PITIFULLY low.

Let's say you are able to save $2,000 per year and invest it in an index fund that mirrors the New York Stock Exchange (NYSE). The stock market has historically returned roughly 10% per year over the past half century (substantially more than any bank can offer). The downside is the increased risk of your money depreciating. You are 22 when you graduate college and plan on retiring at the age of 65. Check out what your retirement nest egg would be after 43 years returning 10% per year:

Initial amount: $0
Annual contribution: $2,000
Annual interest rate (rate of return): 10%
Time: 43 years

With steady saving, investing, and the power of compound interest, you would have a little over $1.3 million when you retired at 65. Here is a financial calculator for you to check out your numbers.


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