Your 20s are one of the most crucial decades in your financial life. Believe it or not, this decade may make or break your ability to retire on time, send your hypothetical future children to college, or have your home paid off before you turn 60.
Here’s why your 20s are so important and what you can do to steer yourself on the right financial track.
The Power of Compound Interest
To explain why your 20s are so important, let’s talk about a little phenomenon called compound interest. It’s so important, Albert Einstein is often quoted as calling it the most powerful force in the universe.
Compound interest refers to money that grows on itself. It is investment income which grows upon its growth. If that sounds abstract, let’s illustrate it with a hypothetical example.
Let’s imagine you have $100. At age 20, you invest this and earn a 10% return. That means, the following year you will have $110.
You keep the entire $110 invested and it earns a 10% return again. In year two, you’ve earned $121: $10 came from the first year and $11 came from the second year.
Why $11 in the second year? Because not only did your original $100 earn a 10% return, the additional $10 that you earned also earned a 10% return of its own—which equals an extra $1. That’s why you have $11 in year two rather than $10.
Your money keeps growing on itself each year until, by year seven, at age 27, your $100 has become $200. This example assumes an annual return of 10%, with taxes deferred and gains compounded. Thanks to compound interest, you’ve doubled your original investment.
This particular example might sound like small potatoes. Who cares about doubling $100 to $200 over the span of seven years? Let’s take another look.
Imagine that you’re not just investing $100. Imagine investing $100 per paycheck, continually, throughout your 20s. Then, imagine that it doesn’t stay invested over the span of seven years, but over 40 years instead.
You now have a significant sum of money on your hands. The longer your money is invested, the more compound interest works in your favor. That’s why you want to keep your money invested for as long as possible.
The best way to achieve this is by starting as early as possible. This is why your 20s are an ideal time to start saving and investing, particularly for long-term goals like retirement. Thanks to compound interest, just a little bit saved now can yield huge results down the road.
When Compound Interest Works Against You
Keep in mind that when it comes to paying off debt, compound interest can work against you.
The longer the interest on your debt grows on itself, the larger and larger the final figures become. Eventually, the interest you pay on your debt becomes equal to or greater than the original amount borrowed.
That’s why your 20s are also a great time to repay any debts you may have accumulated when you were younger—regardless of whether it’s credit card debt, a car loan, or student loan debt. Harness compound interest to work for you, not against you.