Compound interest is the eighth wonder of the world.” - Albert Einstein
Whether you’re an expat or not, the same fundamental advice applies when it comes to saving for retirement: start as soon as possible.
This is because whatever your age, the sooner you start, the more time you are allowing for the power of compound interest to grow your retirement savings.
Compound interest is one of the most important ideas to understand while saving or investing, especially when it comes to planning for retirement as an expat. It lets your money work for you, and ensures that you don’t miss out on the extra wealth you can amass over time.
What are simple and compound interest?
Simple interest is the quickest and most straightforward method of calculating interest on loans, savings accounts, and fixed deposit balances. It is calculated by multiplying the interest rate (in percent) by the principal (amount) and the number of days between payments.
So simple interest paid over a certain period is a fixed percentage of the original amount that was borrowed in the case of a loan, or invested in the case of savings.
Say for example that you deposit $50,000 at a rate of 4% annually. You would have a balance of S$52,000 at the end of the first year, including the $2000 interest on your original $50,000 deposit. Additionally, you would have $52,000 + $2000 = $54,000 in the following year, $56,000 in the next year, and so forth, as the interest paid is always 4% of the original amount deposited if you’re being paid simple interest.
Compound interest on the other hand is the interest earned on the principal amount plus the interest already earned. The advantage of compound interest is that, over time, the interest-on-interest effect can produce much greater returns. The more time you have to save for retirement, the more this effect will be magnified.
Even if you can’t make regular contributions for a while, it will still keep compounding and you will still benefit from exponential growth. Thus, compounding interest can be a powerful ally when building your retirement savings as you let your money accumulate over time.
The more you increase your savings deposits, the more you will see your savings grow more quickly, further taking advantage of compound interest.
Using the same example as above, if your initial deposit is $50,000 at a rate of 4% annually, with simple interest after 20 years you would have $90,000, whereas with compound interest you would have $111,129.10, so 23.5% more. The effect is further amplified if you keep making regular deposits throughout.
This graph (courtesy of Moneygeek) shows the amount of compound interest compared to the original investment:
Benefits of starting saving as early as possible
A 2022 report showed that approximately 70% of seniors would advise their younger selves to begin saving sooner. In the world of compound interest, time is money, because compound interest rewards those who begin early.
At the start of your career, paying off school loans, saving for a down payment on a home, and other expenses may feel like a financial battle for your resources. For a stress-free retirement though, finding money to start saving too can give you a significant economic advantage.
For instance, if you put $1,000 into an account that increases by 5% annually, you will have $1050 at the end of the year. If you invested $1050 in the first year and received a return of 5%, your investment would be worth $1102.50 after two years. If you start early, the returns will be very high by the time you retire. Conversely, if you start later, the returns will be relatively modest.
This also implies that you can initially save less, as time amplifies the value of even relatively small amounts.
You can also have a more growth oriented rather than risk averse investment portfolio if you start saving early. Even if you have ups and downs, over the long term, high risk investments with a high potential return should give you a more significant financial safety net when you retire, owing to the power of compounding.
Compound interest comparative examples
The following two illustrations of compound interest show how it works positively for retirement savings.
Let's imagine that over 20 years, Karl, 25, and Anna, 45, both set aside money for retirement over a 20 year period. They each set aside $10,000 per year for the first ten years, then $20,000 per year for the following ten. We'll suppose that they made their contributions at year's end and that they both achieve a long-term average 6% yearly return, and they both want to retire at age 65.
However, to illustrate the benefit of starting early, we’ll assume that Karl begins saving at age 25 and quits saving at age 44, while Anna begins saving at age 45 and ends saving at age 64. In this scenario, even though they saved the same amounts over the same time period, Karl will have significantly more in his retirement account at age 65 than Anna - Karl ends up with $1,603,000 in total, while Anna has just $499,700.
The power of compounding allows Karl's money to increase over 40 years, as opposed to Anna's over just 20 years. Anna would need to put aside more than three times Karl's annual savings amount to have the same size total amount at age 65 due to her later start to saving.
Hence, you should give yourself as much time as possible when saving for retirement, as you will have more time to benefit from the power of compounding if you start saving and investing earlier for retirement and other goals. It's too good to pass up, so start as soon as possible, whatever your age.
Winding up
Earning compound interest can significantly improve your quality of life in retirement, effectively enabling your money to earn money for you.
Long-term investments in retirement accounts like 401(k)s benefit from both compound interest and tax benefits. Savings accounts, and stock and bond investments also benefit from compound interest over time. If you’re not sure where to save or invest for retirement, schedule a call with your expat financial advisor.
If you have any questions, don't hesitate to contact us.
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