It’s always nice to open up your account and see that your balance has gotten bigger, whether it’s your retirement fund or a savings account. But even if both balances have multiplied, the way these accounts grow (other than by you putting in more money) is actually a little different.
Investment accounts, like a retirement account, could get bigger via the power of compounding through earnings and/or dividends. Savings products like a high-interest savings account, on the other hand, can grow by compound interest. Both types of compounding could help you make money on your money, but how compounding works varies.
We’ll explain how the power of compounding works when it comes to investments like your retirement account, and then briefly touch on compound interest. (You can take a deep dive with us into compound interest here.)
Do you have a retirement account? If so, then you’ve likely seen the power of compounding at work. The longer you leave your money in an account, the more money you could potentially earn. Of course, those potential returns depend on how the market moves (meaning you could lose money, too).
As you probably know, with your retirement account you can receive earnings or dividends (at least, that’s the goal!). The earnings you receive depend on how the assets in your portfolio (think stocks, mutual funds, bonds, etc.) are performing and dividends are paid out by some companies to their shareholders as a distribution of profits. The power of compounding those returns is what makes the long view of retirement saving so important.
Let’s say you have an Individual Retirement Account (IRA) and you invest $6,000, the annual maximum that people younger than 50 can contribute to a traditional or Roth IRA for 2020. If that account hypothetically returns 5% each year, your account balance would grow by $300 during the first year.
Each following year, you’d start with a larger balance, so the 5% hypothetical return would generate even more cash. In the second year, you’d collect almost $315 and in the third year, over $330. At an annual return of 5%, a $6,000 deposit would become $9,773.37 in 10 years, $15,919 in 20 years and $42,240 in 40 years.
Now, these numbers are just based off an initial $6,000 deposit and a 5% return – ideally you’d keep adding to your retirement account year after year. So imagine how much more money you’d rack up if you contributed $6,000 annually, and received those compounding returns. After 20 years (at that same 5% return), that $15,919 could turn into $203,729! (Again, your actual returns depend on how the market performs).
We realize you’re probably familiar with compound interest (even if you didn’t already check out our handy-dandy guide to compound interest) but it deserves a quick shout-out. If you have a savings product, like a savings account or CD (certificate of deposit), it’s likely that you are earning compound interest.
The main point here is that deposit accounts earn interest on your deposit, then that interest gets added to your balance and you earn even more interest on that “new” overall balance. In that way, deposit accounts can sometimes be seen as a less risky investment compared to investing in stocks, for example.
Good to know: compound interest can be compounded daily, monthly, or annually, depending on the terms of your account.
The idea of compounding and its potential to earn money on your money is similar in both investing and saving scenarios. The main difference between them is what you’re potentially earning, whether it’s “interest” or “earnings/dividends” and possibly, how often your money is compounded.
It’s also worth noting that compound returns (on your investments) may not be steady. If your investments lose money this could impact your balance, which could in turn affect your returns.
Still, investing could provide opportunities for you to earn greater returns compared to a traditional savings account. Historically speaking, over long periods, investing in the S&P 500 has generated higher returns than interest earned in a savings account.
Remember - when it comes to compounding, time can be (more) money. If you wait to contribute to your retirement account until 10 or 20 years from now, you may have a lot more money to set aside, but you’ll also have lost 10 or 20 years of potential growth. And after our hypothetical example above, you know that extra time could potentially lead to greater returns. Of course, as we’ve discussed time and time again, investing always comes with risk. Even with the power of compounding, returns are not guaranteed.
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