Compound interest works in the long term

This was originally published on Monday, April, 29, 2013, in the Pacific Daily News.  Click here to subscribe to the PDN.

This month’s articles have been dedicated to retirement plans. There is a good reason why retirement plans work and that is because of something called compound interest. When your money earns compound interest, watch your profits grow exponentially.

Compound interest is basically the interest that accumulates on the balance in your account. It is powerful because it allows you to make money not just on the money you contribute to your account but also on the money it earns. Your retirement savings increases exponentially.

Let’s say by the end of the year, you contribute $1,000 into your retirement plan. You earn a 5-percent rate of return. At the end of the year your balance will be $1,050. If you leave that money alone for a second year with the same 5-percent rate of return, your ending balance will be $1,102.50. In less than 15 years, you would double your original investment.

Now let’s say that instead of leaving your money alone during that second year, you will contribute another $1,000. Your ending balance will be $2,152.50.

Your retirement plan should be just for retirement and should not be used as an emergency fund. You should have a separate account just for emergencies. Because of compound interest if you take money out of the account, the multiplying effect is drastically decreased.

Other reasons you do not want to take a loan from your retirement plan is that you may have to pay a penalty fee for an early withdrawal and the possibility of being double taxed.

The power of compounding interest will work no matter how much you contribute into your retirement account. The most important thing you can do is to start saving as soon as you can, leave the money in the account, and be consistent.

Michael Camacho is president and chief executive officer of Personal Finance Center. He has more than 20 years of experience in retail banking and with financial institutions in Guam and Hawaii. If there is a topic you’d like Michael to cover, please email him at moneymattersguam@yahoo.com and read past columns at the Money Matters blog at www.moneymattersguam.wordpress.com.

 

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