Your Money X (1+i)^n
If that looks like a bunch of gibberish to you, don’t worry – I’m here to explain it (and explain why it’s going to change your life). It has been called many things, from “the greatest mathematical discovery of all time” to “the financial snowball”. No matter what you call it, COMPOUND INTEREST can change your life.
EVERYONE LIKES MONEY – NO ONE LIKES MATH
This concept of compounding interest is incredibly simple, yet it seems to require a finance degree and job on Wall Street in order to explain it to someone else without a 30-slide presentation. It all comes down to three things:
- How much you invest
- The return you get on investment
- How long you invest
These three metrics are all important, but the most important is arguably time. The earlier you begin putting money to work, the longer it has to compound. What does that word even mean?
THE MONEY
I mentioned this mathematical phenomenon in my first guide “9 Ways to Become Financially Fit” and thought it deserved a little more attention considering what it can do for you. So what can it do for you? Let’s look at a couple of examples. Let’s say you invest $1,200 today and never touch it again. In 40 years, that $1,200 is worth about $40,000. Pretty good, not great. What if you invest $1,200 every year between now and that 40th year? Now you’re looking at $480,000. Now we’re talking!
“Investing $1,200 per year would have resulted in a balance of $480,000”
That’s a pretty decent amount of money for anyone, but how about getting to that magic number of $1 million? That would take about $2,500 per year for 40 years…not as crazy as you thought. What is crazy is waiting to get your money working for you. To explain why this is so important, let’s take a look at how it works.
THE MATH
Let’s look at this in the easiest way possible: you give me $100 and I’ll give you a 10% return each year while I hold it. One year from today, you have earned $10 in returns. That means the following year you’ll be earning 10% on $110. Simple stuff, huh? We continue with this arrangement and I pay you $11 the second year. Now you have $121, so in year three I pay you $12.10. By the tenth year, I’m paying you $25.93 and your $100 has turned into about $260. As you can see, it’s not a complicated system:
- Invest money
- Earn returns on that money
- Reinvest the returns
- Earn returns on a larger amount of money
“In the tenth year, you’re earning more interest on money from me than you are from your initial $100 investment!”
The best part – this works whether you have $50 or $50,000 to invest. No matter how big or small, your money can be working for you and could be the difference between working until you’re 70 or retiring with a nice cushion.
WHAT THIS MEANS FOR YOU
This is all exciting stuff, but what does it mean for you? It means you have some decisions to make. Most importantly, how do you invest your money? If your employer offers a 401K, you need to be maximizing your contributions. Most employers offer to match employee contributions by a certain amount. Let’s say it’s $0.50 for every $1.00 you invest. You’re already earnings a 50% return on your money before it’s invested! The maximum contribution is $17,500 annually, so that means you’re earning $8,750 in “returns” before it even has a chance to earn a return in the stock market. On top of that, this money is taken before you pay income taxes, so it lowers the amount of income you pay taxes on. It also grows tax-free, meaning you don’t pay taxes on the gains from investing the money. You pay taxes as you withdraw it in retirement, but that will likely be at a much lower income level and tax rate. Aside from a 401K, there are a number of places to invest your money, depending on a number of questions.
- Why are you investing it?
- When do you need it?
- What type of returns do you want?
These are all questions that should be addressed with every investment you make, and I am going to outline all of the different places you should have your money in a series of posts I’m calling Mattress vs Mutual Fund: Where to Park Your Money. In these posts, I will walk you through all the different places you can put your money, whether you need it tomorrow or the day you retire.
FINAL THOUGHTS FROM NICK
Investing can seem like a daunting task and something that only the wealthy take part in, but the truth is everyone can invest their money to allow it to work for them. Even starting with a small amount per month can make a big difference over a lifetime. My goal is to make sure you have the knowledge to invest your money somewhere that makes sense for you and to help you understand that it is easier to tackle than you might have imagined. If you still have questions, please ask them in the comments below. I would love to discuss anything that you might be thinking about after reading this.
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