Over a long time horizon it is possible to triple or even quadruple the principal that you put into an investment account. By utilizing compound interest along with monthly deposits, investment value can grow significantly over time. Understanding and harnessing the power of compounding is essential to saving enough for important events like your child’s education or your retirement.
The most important thing to understand about compounding interest is that an initial investment of money earns you an increasing amount over time. If you put just $1 into an account and assumed a return of 0.53% per month, equal to 6% per year (a potential long-run return assumption), your dollar would increase in value by less than a penny per month initially. However, as those small returns add to your $1, the principal becomes larger. As the principal becomes larger, you collect the same return on a larger sum of money. The same return on more money is a larger nominal value, and the cycle continues to repeat itself. Below is a chart showing the monthly increase on your $1 investment. As time continues, the amount received per month increases without changing the return rate.
The same concept applies, in a more dramatic form, when contributions are made every month. To put this into perspective, imagine that you are having a child tomorrow and you want to start his or her college fund. You deposit $200 and decide that you will commit to contributing $200 every month until your child goes off to college at 18 years old. The total dollar value that you will have contributed over those 18 years is $43,000. The ending account value would be over $96,600 using the same return assumptions as before. That is more than double the total principal contributed! The following graph demonstrates the principle of compound interest. The line represents your account value including contributions and investment gains.
As the length of time increases, the line slowly becomes steeper and steeper. In other words, the value of your account will increase at an increasing rate as time and contributions continue, without changing your rate of return assumptions. The concept is even more drastic when time and contributions are increased.
If current tuition growth rates continue, babies born in 2015 may need up to $304,000 for private university tuition and $244,000 for public university tuition. While you’re reeling from those numbers, let me assure you that saving that amount of money, while challenging, is, in fact, achievable. Actually, you do not have to save anywhere close to that amount if you utilize the power of compounding early on.
With the same return assumptions as earlier, if you contribute $630 per month into your child’s education plan starting when they are born, that will grow to over $304,000 by the time they are 18 years old. That equates to a contribution of $7560 per year, and total contributions of $136,080 over 18 years. That $136,080 total investment grows into over $304,000 for your child’s education.
Even if you can not meet the $630 per month requirement, $50 or $100 here or there is always better than nothing because it can grow over time. The best way to save for your child’s education is through a 529 Plan. This plan allows you to contribute without being taxed when the money is withdrawn for education related expenses, among with many other benefits. To learn more about the advantages of 529 Plans, please read our blog here.
The power of compounding is not just for your child’s education, but also for your retirement plan. As we mentioned before, the more time and the larger the contribution, the more your money can help itself grow. In 18 years we saw $630 per month grow to well over double the original amount invested. Let’s take a look at what happens when we have 43 years (from age 22 to 65) and a higher monthly contribution.
If you decide to contribute $1000 to your retirement plan per month over that 43 year span, you will have contributed $516,000 total over your working life. The account value when you turn 65 would be over $2,700,000 with the same return assumptions as before. That is more than quintuple the total amount contributed. While $1000 per month can be unachievable for many, similar gains can be seen with smaller amounts. Do your best to put money away as early as possible. By contributing just $400 per month over the same time period you will net more than a million dollars by retirement, so remember to save what you can, when you can.
The power of compounding can be a difficult concept to understand, but by following simple rules it can be easy to take advantage of. First, always contribute when your finances allow for it. This will give your money the maximum amount of time to grow. Second, always maintain your long term investment horizon and keep your end goals in mind. Didn’t I say the steps were simple! By following these two rules you will be able to get the most out of your money and help yourself stay motivated and eager to save.