Saving early is important, as the power of compound interest will help you to reach your savings goal, even with low expected returns. The concept applies for savings towards any goal, such as retirement, purchasing a home, or saving for an education. The longer the timeframe, the larger the impact of the power of compounding.
If you start late, you can still catch up. However, you will need to invest more money, as compounding has much less time to have an effect.
Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.[1]
— Albert Einstein
Compound interest
Compound interest is interest added to the principal of a deposit or loan so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding. A bank account, for example, may have its interest compounded every year: in this case, an account with $1,000 initial principal and 5% interest per year would have a balance of $1,050 at the end of the first year, $1,102.50 at the end of the second year, $1,157.63 at the end of the third year, and so on.
How much more will you get if you start early?
If you invest $6,000 at the beginning of each year[2] (the equivalent of $500 per month, but placed at the beginning of the year for easier calculations), and start at age 55, assuming 4% annualized nominal return,[note 1] your balance at age 65 will be about $75,000. If you start at age 40, you will end up with about $260,000. And if you start at age 25 your balance at age 65 will be about $593,000.[note 2] The graph below illustrates this.
To better understand what is going on, we can separate the amount invested in total from the growth of the invested money at 4% interest. Refer to the figure below.
Going from right to left, the lower (gray) bars represent your contributions. The sooner you start to invest, the more money you will have at retirement.
Now, look at the top (black) bars. Going from right to left, the sooner you start to invest, compounded interest has more time to work. Stated another way, the effect of compounding at age 20 will contribute much more significantly to your savings than contributions made later on.
What does it take to catch up if you start late?
Suppose you want $100,000 at age 65, and the interest rate is again 4%. If you start at age 25, you will need to save only about $1,000 a year. At age 40, you will need to save about $2,300 a year. And if you start at age 55, the amount needed is over $8,000 per year.
The total amount needed to reach $100,000 at age 65 also increases as the saving period gets shorter:
See also
- Comparing investments - The "basics" on the time value of money.
- Invest early and often (Rule #2) - This short video illustrates the miracle of compound interest and the importance of starting to save early with a simple example of two young college graduates.
Notes
- ↑ The 114-year historical record of global stock and bond returns suggests that a globally balanced stock/bond portfolio will likely provide an annualized compound real return between 3% and 4%, assuming minimal expenses and no tax expense. See Global investment portfolios 2015 update, from our site's unofficial (transferred) blog.
- ↑ Calculations are done as:
Starting at age 25: 592,959.22 = FV(4%, 65-25, -6000,0,1)
The last parameter of FV has Type set to 1, which represents a payment due at the beginning of the period.
References
Bogleheads® investing start-up kit |
|---|
| Introduction to investing |
|---|
- Asking portfolio questions
- Behavioral pitfalls
- Importance of saving early
- Importance of saving rate
- Investing start-up kit
- Investment philosophy
- Investment policy statement
- Percentage gain and loss
- Risk
|
| Asset classes |
|---|
|
- Bonds
- Callan periodic table of investment returns
- CDs
- Domestic/international
- Money markets
- Stocks
- Pentagon Federal Credit Union
- Treasury Inflation Protected Securities
|
| Funds |
|---|
|
- ETFs for Bogleheads
- ETFs vs mutual funds
- Index fund
- Indexing
- Mutual fund
- Mutual funds and fees
- Mutual funds for Bogleheads
- Mutual funds: additional costs
- Vanguard target retirement funds
|
| Managing a portfolio |
|---|
|
- Accounts for children
- Asset allocation
- Asset allocation in multiple accounts
- Comparing investments
- Lazy portfolios
- Managing a windfall
- Prioritizing investments
- Rebalancing
- Sharia investing for US investors
- Tactical asset allocation
- Tax loss harvesting
- Tax-efficient fund placement
- Taxable account
|
| Financial advice |
|---|
|
- Financial planner
- Investment adviser
- Robo-adviser
|
| Non-US investors |
|---|
|
- Getting started for non-US investors
- My portfolio: seeking advice
- Building a non-US Boglehead portfolio
- Investing start-up kit for non-US investors
- Investment philosophy for non-US investors
- Simple non-US portfolios
|
Bogleheads® investing start-up kit |
|---|
| Introduction to investing | - Asking portfolio questions
- Behavioral pitfalls
- Importance of saving early
- Importance of saving rate
- Investing start-up kit
- Investment philosophy
- Investment policy statement
- Percentage gain and loss
- Risk
|
|
|---|
| Asset classes | - Bonds
- Callan periodic table of investment returns
- CDs
- Domestic/international
- Money markets
- Stocks
- Pentagon Federal Credit Union
- Treasury Inflation Protected Securities
|
|---|
| Funds | - ETFs for Bogleheads
- ETFs vs mutual funds
- Index fund
- Indexing
- Mutual fund
- Mutual funds and fees
- Mutual funds for Bogleheads
- Mutual funds: additional costs
- Vanguard target retirement funds
|
|---|
| Managing a portfolio | - Accounts for children
- Asset allocation
- Asset allocation in multiple accounts
- Comparing investments
- Lazy portfolios
- Managing a windfall
- Prioritizing investments
- Rebalancing
- Sharia investing for US investors
- Tactical asset allocation
- Tax loss harvesting
- Tax-efficient fund placement
- Taxable account
|
|---|
| Financial advice | - Financial planner
- Investment adviser
- Robo-adviser
|
|---|
| Non-US investors | - Getting started for non-US investors
- My portfolio: seeking advice
- Building a non-US Boglehead portfolio
- Investing start-up kit for non-US investors
- Investment philosophy for non-US investors
- Simple non-US portfolios
|
|---|
FAQs
Saving early is important, as the power of compound interest will help you to reach your savings goal, even with low expected returns. The concept applies for savings towards any goal, such as retirement, purchasing a home, or saving for an education.
Why is saving at an early age important? ›
People who don't prioritize saving money may have less financial stability and be more financially vulnerable than those who make saving a habit from an early age. They don't have extra money to pay for unexpected expenses, which may leave them with no choice but to accrue credit card debt.
Why is it valuable to start savings early? ›
The earlier you start saving, the longer your money can work for you, and the more powerful compound earnings becomes. Compounding is taking the money you earned from your investments and reinvesting it to earn even more, which helps your savings grow faster and faster.
Why is it important to start saving earlier rather than later? ›
Compared to saving aggressively for 10 years, sustained saving over a 30-year period allows you to save less each month and still achieve the same goal as intensively saving for 10 years. Starting the saving journey earlier also means you'll have more disposable funds.
Why is it important to develop the habit of saving money as early as possible? ›
Kids have time on their side—a huge asset when it comes to saving. The sooner a child starts to save, the longer they have to accrue interest, build up funds, and learn valuable financial lessons.
What is the rule of 72 in economics? ›
Do you know the Rule of 72? It's an easy way to calculate just how long it's going to take for your money to double. Just take the number 72 and divide it by the interest rate you hope to earn. That number gives you the approximate number of years it will take for your investment to double.
At what age should you start saving? ›
So what age is the right age to start saving money for your future? The practical answer is any age when you start to work and earn money for yourself, whether it's being paid for chores at age 5 or entering the workforce after law school at age 25. Saving money is a wise financial practice at any age.
Is 27 too late to start saving? ›
It's never too late to start saving money for your retirement. 401(k)s and traditional individual retirement accounts (IRAs) are among the most popular choices. Roth IRAs, tax-advantaged products, and real estate can be other good retirement investment options.
Why saving your first 100k is important? ›
Having $100,000 in savings can be helpful for a number of expenses you may incur, expected or not, including a down payment on a house, sudden medical expenses or other homeownership expenses.
Why do financial experts urge people to start saving as soon as possible? ›
But perhaps the most important variable is the one that's priceless: time. People with the most time on their side are those most likely to achieve their retirement goals. Those who save early end up way ahead of their procrastinating peers.
One key benefit to starting to save earlier in life is making the most of compound growth. When you invest your money, you stand to benefit from compound growth, which is similar to compound interest.
What is the 50 30 20 rule? ›
The 50-30-20 budget rule states that you should spend up to 50% of your after-tax income on needs and obligations that you must have or must do. The remaining half should dedicate 20% to savings, leaving 30% to be spent on things you want but don't necessarily need.
Is never too late to start saving money? ›
Despite popular belief, it's never too late to start planning for your golden years. Of course, experts recommend beginning as early as possible, but even if you're a late bloomer to retirement savings, you can still make a difference for your financial future.
Why is it important to start investing as early as possible? ›
Because investments grow at an exponential rate, meaning it builds onto itself, investing earlier will leave you with a significant larger retirement sum than if you had chosen to wait. There are many ways to invest your money and make it work for you.
Do you think it's best to invest earlier or later in life? ›
In this system, not only does your initial investment generate earnings, but your reinvested interest will also start working for you over time. Put another way, a dollar saved early in your life is worth more in retirement than a dollar saved later in your life because it would generate more interest over time.
Why should you start saving even with a small income? ›
Commit to saving money regularly
If specific goals seems out of reach for you, any amount you can put in savings will help provide a cushion against future financial hard times or big purchases. This is important for everyone, but especially if you are supporting yourself financially.
Why is saving important in development? ›
Savings not only allow for growth in income and increases in consumption, but also for the smoothing of consumption in the presence of various uncertainties.
Why is it important to start contributing early to any savings plan? ›
The earlier you start saving, the longer your money can earn interest and grow. Using automatic deposits can be a good way to save money. Contact your financial institution to transfer a set amount of your pay automatically in a savings account.
What is the value of learning to save your money at an early age? ›
The value of learning to save your money at an early age is that saved money grows and achieves higher interest rates. thus you have available money for unpredictable circ*mstances like health fluctuations, marriage or job. you also have many options to pay what you want which helps you to create a stable life.
Why is saving before spending important? ›
Putting aside money for future use can help you meet life goals. Saving money for emergencies, short-term goals and long-term goals are all important.
