The Magic of Compound Interest

Compound Interest is an important concept to understand in helping you build your wealth.  Understanding compound interest will help you understand why it is important to get the best interest and yield on your accounts. It’s not magic it’s math, and it helps you grow your wealth.

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Compound interest is what can make your deposits grow faster, similar to the “snowball effect.” When you roll a snowball down the hill, the snowball continues to grow upon itself and ends up growing so big it becomes a giant avalanche. Compound interest works relatively the same way, earning money on your initial deposit and on the interest that you earned, as well.  This cycle of compounding your investment and the interest that you earn leads to significant increases in the balance over time. The compounding of interest can happen in several manners depending on the compounding period, which can be measured daily, monthly, quarterly, or annually. In most cases interest is calculated on a monthly basis. This is typically the case with savings accounts and certificates of deposits (CDs). When shopping rates, look at the annual percentage yield (A.P.Y.), it is the true rate that takes the compounding into account on an annual basis.

In the example below, the initial deposit is $10,000 with an annual compound interest rate of 5%. The money is left in an investment account for fifty years. After the first year you have made $500 in interest and have a total amount of $10,500. That $10,500 is earning interest the entire second year and now you made $525 in interest with a total balance of $11,025. This happens year after year, and at the end of the fifty years you have $114,674 without ever adding to the principle investment.  That is the magic of compound interest.

Compound Interest AnnuallyTotal
Year 1$10,000 x 5% = $500$10,500.00
Year 2$10,500 x 5%= $525$11,025.00
Year 3$11,025 x 5% = $551.25$11,576.25
Year 4$11,576.25 x 5% = $578.81$12,155.06
Year 5$12,155.06 x 5% = $607.75$12,762.81
Year 10$15,513.25 x 5% = $775.66$16,288.91
Year 25$32,251.00 x 5% = $1,612.55$33,863.55
Year 50$109,213.33 x5% = $5,460.67$114,674.00

Compound interest works in your favor, especially when you are able to deposit funds and leave them to grow. Combining compound interest with periodic deposits to your account, perhaps on regular intervals, helps you build savings for your future even faster.

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Let’s take a look at the magic of compound interest while continuing to contribute to the principle of the investment. We can deposit the same $10,000, in the same investment account earning a 5% yield and compounding monthly. With this example, we add an additional $250 each month to the account. Compounding monthly we will need to divide the interest rate by twelve for the amount being paid on a monthly basis. Because we are earning a 5% yield on an annual basis, we will be earning 0.41667% on a monthly basis. After the first month we would earn $41.67 in interest and deposit an additional $250, bringing the total balance to $10,291.67. Doing this for next five years would result in having an account worth $29,832.11. After fifty years, the account balance would be $788,357.98 with a total contribution of only $160,000 ($10,000 initially and $150,000 in monthly deposits) over the fifty-year period.

Saving $250 Per Month With Compound Interest MonthlyTotal
Month 1$10,000 x (5%/12) = $41.67 + $250$10,291.67
Month 2$10,291.67 x (5%/12) = $42.88 + $250$10,584.55
Month 3$10,584.55 x (5%/12) =  $44.10 +$250$10,878.65
Month 12 Year 1$13,276.02 x (5%/12) = $55.32 + $250$13,581.33
Month 24 Year 2$17,024.96 x (5%/12) = $70.94 + $250$17,345.89
Month 36 Year 3$20,965.70 x (5%/12) = $87.36 + $250$21,303.06
Month 60 Year 5$29,462.35 x (5%/12) = $122.76 + $250$29,835.11
Month 120 Year 10$54,812.29 x (5%/12) = $228.38 + $250$55,290.68
Month 300 Year 25$182,679.29 x (5%/12) = $761.16 + $250$183,690.46
Month 600 Year 50$784,837.82 x (5%/12) = $3,270.16 + $250$788,357.98

No matter how you choose to save for your future, the most important thing that you can do now is to open an account and start contributing to it on a regular basis, whether you’re starting a savings account, retirement account, or a standard investment account, this will allow you to take full advantage of compounding interest rates. The sooner you begin investing, the larger you balances will be when you reach retirement age. Compound interest rates will work in your favor over the long run. 

Tell me your stories and your thoughts by leaving a comment below. Let’s have a better money conversation.

Dollar Cost Averaging to Build Your Wealth.

The strategy behind dollar cost averaging consists in making regular contributions of a set dollar amount towards the same fund or stock over a long period of time regardless of the market conditions in contrast to investing a lump sum all at once. Many of us are already doing this in our retirement plans, as we are setting aside a percentage of our income towards our retirements. That money is then invested in the funds that you or your plan administrator has selected for you inside your retirement plan. This form of investing allows you to purchase more shares when prices are low and fewer shares when prices are high, averaging out the cost of your investment.

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DatePrice Per ShareSharesCost
April 1st$20.0050$1,000.00
May 1st$15.0066.66$1,000.00
June 1st$10.00100$1,000.00
July 1st$1855.55$1,000.00
Total:272.22$4,000.00
Average Price Per Share:$14.69

Let’s see how it works. Consider investing $1,000.00 per month over the next four months into a fund with relative volatility. The first month you invest $1,000.00 at $20.00 per share purchasing 50 shares, the second month the price is down to $15.00 per share where your $1,000.00 purchases 66.66 shares, the third month the price is down to $10.00 per share and you obtain 100 shares, the fourth month the price is now $18.00 per share and your $1,000.00 equates to 55.55 shares. In total over the four months you have purchased 272.22 shares spending a total of $4,000.00, dividing the cost by the total number of shares your average price per share is $14.69. See further examples with dollar cost averaging the S&P 500.

Broad diversification of your investment portfolio being one of the most important things that you can do for your investments, think of dollar cost averaging as the diversification of time. By diversifying your investment over a select time period, it reduces the risk that you’re investing at an inopportune period of the market.

If you are thinking that it would just be better having purchased all the shares at the $10.00 value, you are right it would have been. However timing the market for the average investor is a sucker’s game, even with all of the information available these days there is no way to know when the market will go up or down and by how much. Dollar cost averaging may not be the most effective investment strategy when looking for total return verse that of investing a lump sum at one moment but most of the world does not have large cash reserves sitting around to invest in one lump sum. Dollar cost averaging is one investment strategy to adopt to ensure that some of your savings goes to work for you.

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Most importantly, the practice of dollar cost averaging creates a good habit of investing for your future. Every dollar that can work for us in the longer time horizon the more secure we will be in the future when we need the money. Leave a comment below and let’s start a better money discussion.

Demystifying your 401(k), IRA, and Roth IRA

With so many options and so much noise when looking at different retirement programs let’s take a look at demystifying the three of the most common types of retirement accounts. Not so fun facts: According to Northwestern Mutual 1 in 3 Americans have less than $5,000 in retirement savings with one in five having no retirement savings what-so-ever.  Most advisors will recommend that during retirement you will need seventy to eighty percent of our preretirement earnings to maintain our current way of life before entering into retirement. The largest consideration of that number is if you have your home paid for or not. To avoid working, literally, for the rest of your life it is important to know where you can put your money to help you prepare for the golden years ahead.  

Traditional 401(k):

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The most popular form is a “defined contribution” retirement plan, more generally speaking this is a retirement plan where the employee, employer, and or both parties contribute a specific percentage or dollar amount of their income towards the employee’s retirement. Contributions are excluded from the employee’s gross income on a pre-tax basis, that is before taxes are accounted for on your check, and grow tax deferred until the funds are withdrawn during retirement, so you do not pay taxes on the money until you start collecting your retirement.

This should be the first place that you place your money when this option is available to you as part of your employer’s benefits, plus you will have the money come directly out of your paycheck and that is making savings automatic and easy for you.  On top of that, most employers offer a match of a certain percentage of your income and you should always contribute enough to participate in the full match. Let’s repeat that, if you are not able to contribute the maximum amount to your 401(k), contribute at least the amount that your employer is matching. If you are not participating to the full match you are giving up free money. For example, if you are making $48,000 per year and your employer matches 3% per check, getting paid twice a month at $2000, your employer is giving you $1,440 per year as long as you are putting at least that much in your 401(k) as well. Over time those funds will compound and grow.

For the 2020 tax year the IRS limits of contributions to your 401(k) plan are capped at $19,500 and $26,000 for those 50. The difference over 50 is called catch-up contributions, and regardless of how much you have saved, that limit is available for all individuals over 50 participating in their employer’s 401(k) plan. It’s important to remember that even a little bit of savings helps and if your employer is offering a 401(k) plan, participate.

IRA:

IRAs were made to encourage individuals with earned income to save for retirement in addition to other retirement plans they have. Also known as traditional IRA accounts, all deposits made to your IRA are made on a pre-tax basis and grow tax deferred until the funds are withdrawn during retirement, age 59 ½ or older, similar to that of your traditional 401(k) plan. The funds placed into an IRA account are still available to you should you not wait to retire however, there is a ten percent additional tax penalty for early withdrawal prior to age 59 ½ with a few exceptions.

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For the 2020 tax year the IRS limits of contributions to your IRA are capped at $6,000 or the amount equal to your taxable compensation for the year if less than $6,000. However if you are age 50 or older you are eligible to add an additional $1,000 “catch-up” deposit to your annual contributions. The good news is this year as of the 2020 tax year, there is no longer an age limit on making contributions to your IRA as long as you are still having earned income, however you must begin taking minimum required distributions the calendar year in which you turn 70 1/2, you are born before July 1, 1949 and 72 ½, if you are born after June 30, 1949.

There are several different choices in investment vehicles within your IRA depending on what type of account you opened and your risk profile. Most banks and investment institutions have basic IRA savings accounts or CD’s where your retirement money can sit in FDIC insured accounts or brokerage accounts that will allow you to invest. Whichever way you choose is right for you, but please seek the advice of a professional and educate yourself in your choices.

Roth IRA:

A Roth IRA allows the same contributions amounts as the traditional IRA. The total maximum amount that you can deposit to your IRAs, traditional and Roth is capped at $6,000 and $7,000 for those 50 and older total combined.  

The difference between the two comes in the timing of the tax benefits. Opposed to the traditional IRA pre-tax dollars that lower your taxable income this year growing tax deferred, the Roth IRA is funded with post taxed dollars that are not taxed at the time of withdrawal during retirement.

Roth IRAs have no required minimum distribution at any age at this time, but there are limits to the income that you make to if you can contribute. The income eligibility as of the 2020 tax year if single, head of house has income limits of less than $124,000 and if married filing jointly less than $196,000. This is a great vehicle for your money as well when saving for retirement, especially if you believe that your taxes will increase in your retirement years.

Not one or all of these are created to be your only tool for retirement, remember saving now will allow you to enjoy retirement latter. Saving as much as you can now will give your funds more time to grow, taking advantage of compounding interest and market growth.

Regardless of your approach, tell me how it is going and let’s start a better money discussion.