ScaredyCatGuide to the 401(k) - Part 4: The Power of Compunding Returns

Ever hear of the snowball effect? This is kind of the same thing. As the mass gets bigger it collects even more and grows faster.

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THE POWER OF COMPOUNDING INTEREST

Here is the calculation that changes your investing life:
• Compound Interest = Your money x (1 + i)n

I know what you are thinking. What is this black magic on the page?

The simple explanation of compound interest is interest earned on money that was previously earned as interest. This cycle leads to increasing interest and account balances at an increasing rate, sometimes known as exponential growth.

To understand how it works let’s start with this concept: you deposit money and that money earns interest.

For example, if you earn 10% on your money, a deposit of $1,000 would gain you $100 after a year one. What happens the next year? Well, this is where the compounding begins. You now earn interest on your initial deposit as well as interest on the interest you just earned.

Therefore the interest you earn the second year will be more than the year before since the balance is $1,100, not $1,000.

This is how your earnings accelerate.

• Year one: deposit of $1,000 earns 10% or $100, bringing the balance to $1,100

• Year two: $1,100 earns 10% or $110, bringing the balance to $1,210

• Year three: $1,210 earns 10% or $121 bringing the balance to $1,331

Above is an example of compounding yearly. If you are getting an annual return of 10% in your 401(k) holdings this is how it begins to grow exponentially.

This is why every extra dollar you can keep in your retirement accounts is vital. It adds to your snowball’s rate of your of growth.

The best part – this doesn’t take a lot of work a lot of work to reduce the fees you are paying.

Once you get an understanding of how the fees are derived all it takes is a few changes and you let it go to work.

Whether you are a retiring in 10, 20 or 30 years cutting your fees puts a good chunk of money back in your retirement account.
It really could mean the difference between working into your 70’s or retiring comfortably when it comes time to call it a career.

If you want to see how much, there are several investment cost calculators out on the web. The one used for the example account above can be found here: https://www.mywealthtrace.com/compare-investment-fees-calculator

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So true. Compounding is what Warren Buffett espouses most.