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Financial Life Planning Advisors

The Power of Compound Interest

You know it’s important to save for emergencies, your kid’s college education, retirement. But why else is saving now so important?

Compound interest. It’s an easy way to increase what you’re saving, and if you get started now, you can let compounding potentially grow your retirement savings. You’ll start by earning interest on your investments, after which that interest will earn interest on itself, and so on through the years.

But for this to work efficiently, you always have to pay yourself first. It’s the golden rule of personal finance. If you aren’t doing it already, make sure a portion of your income is automatically going into a savings or investment account. You’ll receive a smaller paycheck, but you’ll build up your savings without even realizing it. 

You’ll essentially be paying yourself before paying for living expenses and discretionary purchases. And doing it automatically will make sure you can’t back out, skip a contribution or spend savings funds on entertainment. It creates a consistent stream into your investment account. From day one, compound interest will start working its magic.

How does compound interest work?

Compound interest is often thought of as “interest on interest.” It’s much more effective than simple interest, which is calculated on just the principal amount, because your interest earnings generate earnings of their own over time. The rate of accrual depends on the frequency of compounding: The higher the number of compounding periods, the greater the compound interest. For example, a $100 investment compounded at 10% annually for 5 years will be lower than $100 compounded at 5% semi-annually for 5 years.

You can also consider the rule of 72. It’s a straightforward way to calculate how long it will take for your initial investment to double at a specific interest rate if you don’t make any future contributions. All you have to do is take the number 72 and divide it by the interest rate you hope to earn to see how many years it will take for your initial investment to double. So, if you have an $5,000 investment with an average 6% rate of return, it will take about 12 years to reach a savings of $10,000 (72 / 6 = 12).

When should you save?

The best part is that saving and investing just a small amount can possibly go a long way. If you’re early in your career or savings goals, it may make sense (and make you more comfortable) to start with a low investment amount—and that’s okay! Regardless of your initial investment, it’s possible that your investment will grow over time with compound interest.

Setting aside just $50 to your monthly contribution will add up over the years. Time is on your side when it comes to compound interest, so the sooner you get started, the more accumulation you’re likely to see by the time you’re ready to retire.

Another little piece of advice? Don’t act based on market trends or behaviors. As an individual investor, focus on your personal goals. With compound interest and a consistent contribution on your side, you might just be able to reach your future goals!

Disclaimer: Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss.

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Check the background of this financial professional on FINRA's BrokerCheck