The Power of Compounding by ashtenlail

The Power of Compounding

amlail — 2014-09-03 16:30:34 UTC

A large part of becoming an adult involves planning for your future and deciding what to do concerning your retirement. Unless you plan to work until you are physically unable, it is important to consider the different options available to you. Do you want to invest one lump sum at the beginning and let it accrue interest, or do you want to wait and make monthly contributions to a retirement fund?

Let's explore the options!

Option 1

amlail — 2014-09-03 16:33:42 UTC

Let's pretend you have $10,000 that you just inherited on your 20th birthday. You know that it's important to plan for the future, so instead of buying a new car or taking a whirlwind tour of Europe, you decide to put that money in an account to accumulate interest for your retirement at age 65. You put it in an account that pays 8% interest compounded monthly. So, how much do you end up investing in the end? How much will you end up with? One quick step with a calculator will tell.

N: 45 years

I%: 8

PV: 10000

PMT: 0

FV: 361635.99

P/Y: 1

C/Y: 12

At the end of the 45 years, when you can finally retire and access the money, you will have a nest egg of $361,635.99. Considering you only invested $10,000, a nest egg like that is pretty impressive! But let's explore another option...

Option 2

amlail — 2014-09-04 01:16:08 UTC

Maybe when you're 20 years old, you're a broke college student and don't have $10,000 to put in a retirement fund-- all your money is going towards school! You decide to put off investing your money until you are 30 years old, with a stable job and income. When you reach 30, you make the decision to put $1,000 away every year for 35 years until you retire at age 65. You deposit your payments in an account that pays 8% interest compounded monthly. So, will investing $1000 per year result in a larger nest egg? Or will you just end up investing more money for a smaller return? Our handy calculators can figure that out for us!

N: 35 years

I%: 8

PV: 0

PMT: 1000

FV: 184248.68

P/Y: 1

C/Y: 12

When the 35 years are up, you will have invested $35,000. After you hit the golden retirement age, you will have earned yourself a nest egg of $184,248.68.

So what's the better option?

amlail — 2014-09-04 01:25:41 UTC

Let's look at the differences between the two.

Option 1 is an investment that compounds the initial sum every month over a period of 45 years. Option 2 is an annuity, where you invest $1000 every year for 35 years.

For option 1, you have to have the self discipline to make the initial investment of $10,000; that option isn't necessarily the best fit for everyone.

With option 2, you get to put off the payment for ten years, but you have to commit to making that payment of $1000 every year. If your income is flexible iris likely to change over the course of 35 years, this may not be the best option.

There is a difference in the size of the nest egg produced by each option. Going with option 1 is going to result in a nest egg larger by $177,387.31. So, if you're willing to make that initial investment of $10,00, you are going to be much better off when you retire at age 65.

What can we take away from this?

amlail — 2014-09-04 01:35:03 UTC

Choosing the best retirement plan is a tough choice that is entirely dependent upon the individual and their current financial situation. As long as you're setting money aside for retirement, there's really no "wrong" way of doing it.

If somebody has the financial capability to put aside a chunk of money early on (and the restraint to leave it alone for 35-45 years) then they should take advantage of that opportunity so they can capitalize on their investment. It would take a 20 year old a lot of self-discipline and responsibility to put a large sum of money in an account out of their reach, but if it can be done, it should be!

However, not everybody has the ability to set aside that much money at such a young age, and that's perfectly understandable! Putting it off for a few years and making yearly payments will mean you will end up with a smaller nest egg, but that is certainly better than nothing at all! This may be a more reasonable option for some people.

In the end, it's important for people to examine their current financial situation and do their research to determine which option is going to be the best one for them. Each person has a unique set of circumstances, but so long as they're setting aside money for retirement, they're doing the right thing!

amlail — 2014-09-04 01:48:32 UTC

amlail — 2014-09-04 01:50:37 UTC

WOW!!!

pjeggleton — 2014-09-08 13:15:20 UTC

This was incredible! Nice creativity. Excellent discussions!! 20/20