From Here to Financial Happiness

Day Six Piling It On

Yesterday, I harangued you to fund your 401(k) and pay off your credit cards. Why? Both show the power of compounding – for better and worse.

Compounding is the process by which money grows. Each year, we earn returns not only on our original investment but also on gains from previous years that were left in the account.

Let's say our money earns 6% a year. If we invested $1,000 and there was no compounding, we would collect $60 every year, leaving us with $1,600 after 10 years, $2,200 after 20 years, and $2,800 after 30 years. But thanks to compounding, the actual figures are far larger – $1,791 after 10 years, $3,207 after 20 years, and $5,743 after 30 years.

That $5,743 after 30 years is more than twice as large as the $2,800 we would have amassed without compounding. That means roughly half the final account balance came from gains on the original $1,000 investment – but the other half came from investment gains earned on investment gains. We left those gains in the account and they went on to earn additional gains. How cool is that?

Moreover, if we contribute to a 401(k) with an employer match, we'll enjoy compounding both on the money we invest and on the money contributed by our employer. Over time, the results can be spectacular. Let's say we save $5,000 a year for 40 years in a 401(k) plan and our employer matches our contributions at 50 cents on the dollar, so we receive an additional $2,500 each year. Assuming a 6% return, we would have more ...