Experts on personal finance may disagree on a lot of things but they all agree on one thing –thpower of compound interest. Albert Einstein may or may not have called it the most powerful force in the universe. But one thing’s for certain — it can either work for you or against you.
Putting compound interest to work for you
Compound interest is your friend when you put it to work for you, Here’s an example of this. Let’s suppose you put $100 in an investment that pays 10% compounded semi-annually. In this case you’d have $110 at the end of the year. Then at the end of year two you’d have $121 ($110 + 10% = $121). And the $21 would be passive income as you didn’t have to do anything to earn it.
$21 may not sound like much … but
The fact that $100 earned you $21 in just two years may not sound like a really good deal but look what happens if you put $5000 in that investment with 10% interest compounded semi-annually. You’d have $6077.53 at the end of two years with $1073.53 in interest and $8144.48 at the end of five years with $3144.48 just in interest. And again, this is passive income because you didn’t have to lift a finger to earn it.
The dark side
Compound interest becomes your enemy when it goes to the dark side – that is, when you’re paying it instead of receiving it. For example, if you owed that $5000 on a credit card at 15% interest and made a fixed payment of $200 a month, it would take you 31 months to repay the $5000 and would cost you $5,729.21 in interest or more than your original balance.
A more powerful force>/h2>
Despite what Albert Einstein may or may not have said there is a force more powerful than compound interest.
It’s the magic doubling penny.
The way it works is incredibly simple. You invest in something that gets you a penny the first day and then doubles to two cents the second day. By day 10 that penny is now $5.12, which probably doesn’t sound like much but by day 20 it will have turned into $5,242.88 and $5,368,709.12 by day 30 – or the end of just one month.
So which would you rather have – compound interest or the magic doubling penny?
There is no such thing
Wouldn’t it be great to invest one penny and then have more than $5,000,000 after just 30 days? You could retire to a warm country with great beaches and spend the rest of your life lying around in a hammock and drinking Pina Coladas. Unfortunately, there is no such thing as an investment where you would start with a penny and see it double every day. But you could harness the power of compound interest to have a nice retirement or even retire early.
If you’re not saving for retirement now
If you’re already saving for retirement, congratulations! That puts you ahead of 33% of the people recently surveyed that reported they have saved nothing for retirement. If you’re part of that group, you absolutely must get started or you could literally end up working until you die.
Just a few dollars a week
If all you can afford to save at this point in your life is a few dollars a week, that’s okay. The important thing is to get started and to build a savings habit. You can always increase that few dollars a week to $25, $50 or even $100 as your earnings increase.
A traditional vs. a Roth IRA
Your employer must not offer a 401(k) or you would certainly be taking advantage of it. Or maybe you’re self-employed. In either case you could open a traditional or Roth IRA and start putting money into it. There are several important differences between these two plans but the biggest has to do with income taxes. If you choose a traditional IRA, the money you put in it is tax exempt until you retire and begin withdrawing from it. A Roth IRA is almost the exact opposite – the money you invest in it is taxed but it’s tax free when you begin making withdrawals.
Be careful and diversify
Whether you choose a traditional or Roth IRA do be careful, diversify your investments and stay away from individual stocks. Even professional stock pickers are often wrong and it’s something they do full time. Invest instead in mutual and index funds where you might not see compound interest but you will be spreading you risk and are almost guaranteed see good, steady growth over the years until you’re ready to retire.