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Compound interest – 5 things you need to know

Financial Tip of the Week from the Iowa Bankers Association:

You've probably heard it before: "It's never too late to start saving for retirement."  In the back of your mind you know it's important to save for the future, yet you may have put saving for retirement on the back burner.  Maybe you are waiting another year or two, for your next raise, until you find a new job or until you pay down your debts – but you should know that the longer you wait to start saving, the more you are missing out on the power of compound interest. 

Compound interest refers to interest you earn not only on the money you originally invested, but also on any interest the investment has already earned.  Since April is National Financial Literacy Month, it is a great time for us to take a closer look at the power of compound interest and how it can help boost your retirement savings. Here are five things you need to know:

1)       Time is money – literally.  To take full advantage of compound interest, you'll want to start early.  Waiting one year (or five years) to start saving will be costly.  When it comes to compound interest, time is incredibly valuable.  Ready to see how it works? 

  • If you save $100 per month starting at age 20 (with an interest rate of 8%) your savings will total nearly $530,000 at age 65.
  • What if you waited 10 years?  If you save $100 per month starting at age 30  (assuming the same interest rate of 8%) your savings will total nearly $230,000 at age 65.That is a difference of $300,000! 
  • And if you waited another 10 years and started saving $100 per month at age 40 (assuming the same interest rate of 8%), your savings will only grow to approximately $95,000. As you can see, the power of compound interest – and the value of time – is astonishing! 

2)       Decide how much to save. When it comes to compound interest, the example above showed that time is the most critical factor. But it's also important to save regularly. In the examples above, you saved $100 per month.  In reality, the amount that you should save per month is based on your income, your spending habits, your retirement goals and what your budget will allow.  The amount of money you'll need in retirement is also impacted by inflation, your life expectancy and your lifestyle. If saving is not a part of your monthly budget, start to make it a priority.  Starting to save even a little money today is better than waiting until next month (or not saving at all).

3)       Decide where to save your money.  When you've figured out how much to save, you'll need to decide where you save your money. The sample calculations above assumed that you earned an interest rate of 8 percent each year. You may save your money in a tax-sheltered savings plan, such as a 401(k) or 403(b).   Other options that may be available include the traditional individual retirement account (IRA) and the newer Roth IRA.  Each type of retirement account has different tax implications and eligibility requirements, so you'll want to consult a tax advisor to discuss what is best for you.  You can also choose to invest in individual stocks, bonds, mutual funds or cash accounts like savings accounts and certificates of deposit. Before you make any major investment decisions, you may want to contact a professional financial advisor to discuss the risks of any particular investment.

4)       Get in the habit of saving each month.  Automatic deductions make saving easy.  Your employer may be able to automatically deduct a portion of your paycheck to contribute to a tax-sheltered savings plan. Your local banker is also a great resource.  Your bank can help you set up an automatic transfer to automatically move money from your checking account to your savings account each month so you don't have to think twice about it!

5)       Be patient and watch your money grow!   Keep in mind that all of the calculations provided above are based on the fact that you did not touch your money while it was growing.  You may be penalized for dipping into some types of retirement savings early.  Plan to sit back, be patient and watch your money grow – 15, 20, 30 and 40 years down the road, you'll be glad you did!

These financial tips are provided by the Iowa Bankers Association (IBA), representing banks and thrifts in the state. The IBA is a proud sponsor of Money Smart Week Iowa, taking place April 17-24, 2010. Learn more at www.moneysmartweek.com/iowa

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