Tip of the Week
The sooner you can start saving and investing, the more compounding can work for you.
- Part of your budget should always include saving. Maybe you can’t manage putting away 20% of your income, as some experts might recommend. That’s okay. Putting away even a few dollars a week can really add up over time.
- Examine your variable expensesVariable expenses are monthly costs that are flexible. These can include what you pay for food, clothing, and entertainment. each month. Do you really need a take-out coffee or sandwich every day? Over the course of a year, you can potentially save hundreds, or even thousands of dollars by packing your lunch or bringing coffee in a thermos.
- Start by building an emergency fund. The general rule is to have at least three to six months of expenses. But setting aside even a few hundred dollars for unexpected costs is great. Consider putting this money in an account that’s considered safe, such as an FDIC-protected bank account.
- Then think about investing money beyond your emergency fund, in an investing account. The average return for U.S. large cap investments for 2019 is estimated to be about 5.25%, according to some experts. And your money is likely to compound over time.
What is compounding?
Compounding is any return earned on your principal, plus your past returns.
First, let’s explain compounding. Compounding is essentially a snowball effect involving the interest or earnings your money can make as it continues to earn more interest or some other return over time. For example, if you start with $100 and put $50 a month away for ten years, with an annual return of 5.25%. You’ll have slightly more than $7,800, but you’ll only have put away $6,100. Compounding could add about $1,700 to what you save.
Now let’s show you how time can work on your side. The sooner you start investing, the more money can work for you through the power of compounding. Notice the difference between how much someone can save by the time they’re 65 if they start at 25, versus starting at 35.
For both charts, we assume you start with $100 and put $50 away each month, with an annual return of 5.25%. The person who starts at 25 will save a total of $24,100 over the next 40 years, compared to the person who starts at 35, who will save $18,100.
But the person who starts at 25 will end up with nearly twice as much money, just for starting ten years earlier.
By starting early, the person who starts at 25 will save $24,100 by the time they’re 65. Compounding will add an additional $53,732, for a total of $77,832.
By starting later, the person who starts investing at 35 will save $18,100 by the time they’re 65. Compounding will add $23,981.88 for a total of $42,081.88
As you can see, the person who starts ten years earlier winds up with nearly twice as much money, even though they only save $6,000 more dollars. The extra money that the person who invests for longer could wind up with is all thanks to the power of time and compounding.
Find out more
The Power Of Compounding
Compounding is one of the most important lessons for beginning investors to understand. This story will explain how your money can make money as it accumulates earnings and interest over time.
Read our learning guide on retirement savings, which will explain why it’s important to start saving as much as you can from an early age. We’ll also tell you about the different retirement accounts you can set up, and how a Roth IRA is different from a traditional IRA.