Time is on your side, millennials!
While childhood, school years, and first jobs may have seemed to pass in the blink of an eye, retirement might still feel like a lifetime away for millennials. And while it’s definitely far off in the future, compound interest means you can never start saving too early for such long-term savings goals – it can give you a huge boost up.
When it comes to financial planning for younger savers, compound interest, paying down debt, and building an emergency fund are interrelated. Here’s how:
What is compound interest?
Compound interest is when your money can make even more money. Say you earn 5 percent interest annually. If you start with $1,000, you’ll have $1,050 by the end of one year. You’ll then earn 5 percent on $1,050, which will yield $52.50 in interest paid into your account. Thus, the balance at the end of two years will be $1,102.50. Your interest is earning its own interest, which in this case amounts to $2.50.
To get a better sense of how much of a return you’ll realize given a particular scenario, check out this Compound Interest Calculator by the SEC.
Compound interest is essentially free money. Over time, a little bit each year will add up to a substantial contribution to your savings. Or, it can work in the reverse…
How paying off debt is a way of saving money
In the same way that accrued interest is added to the balance of a savings account, accrued interest on a debt will be added to the principal amount. You will then be charged interest on the new larger principal amount. It’s easy to see how, by simply making the minimum payment, you will end up making larger debt payments over a longer period of time.
In addition to making more than the minimum payment, there are other ways to avoid increasing your principal debt with accrued interest. For example, federal student loans begin accruing interest as soon as they are dispensed. However, borrowers are not required to begin making payments until 6 months after they have dropped below part-time enrollment or graduated. Thus, the interest accrued before payments are required and during the 6-month grace period is capitalized, or added to the principal amount. To avoid paying interest on interest in this scenario, you can simply pay off the accrued interest before it capitalizes, either on a monthly basis or in one lump sum.
When you’re paying debt down, you are decreasing the amount of money you would be paying on interest, hence why paying off debt is a form of savings. You are also paying off the principal faster. This frees up your money sooner to save for things like your first house, retirement, or…
An emergency fund
Emergency savings is an important part of financial planning for savers, especially millennials. Having adequate emergency savings helps you avoid taking on additional debt through credit cards and other high-interest lines of credit to pay for unanticipated expenses. Instead, by drawing upon an emergency fund, you are essentially borrowing from yourself at a 0 percent interest rate, to be repaid and rebuilt as soon as possible. Aim for a $500-$1,000 base, and strive to work your way up from there.
Now that you understand the huge potential compound interest holds, check out these long-term savings goal resources: