The magic of compounding
You've heard about the magic of compounding. What exactly does that mean? Compounding refers to the ability of investments to generate earnings. The earnings are then reinvested and generate more earnings. And this wonderful cycle continues until you potentially become very wealthy.
Let's say you save $2,000 every year for 20 years, and your investments earn 8 percent annually. If you start at age 25 and contribute until age 45 and then save nothing further, by age 65 you'd have roughly $426,000. But if you wait until age 35 to begin saving $2,000 a year for 20 years and then retire at 65, your kitty would amount to about $198,000. In both scenarios your out-of-pocket contribution is $40,000.
The compounding equation:
Lots of time + Savings + Interest rate above inflation = Lots of money potentially
Put another way, the more time you have to save, the more compounding will work to boost even paltry amounts into significant savings, says Certified Financial Planner Amy Whitlatch, a fee-only practitioner in Cincinnati.
For example, let's say you save $50 a month by brown-bagging it instead of buying lunch. If you put that money away for 30 years, earning 7 percent annually, you'll wind up with $61,000.
"A small change in mindless spending can translate into serious retirement savings," says Whitlatch. "You do it regularly, and the compounding works miracles."