During these summer months, many teenagers are working – or will be looking for a job – as a means of earning a little spending money. While there is certainly nothing wrong with spending a little of that hard-earned money, some of the money should be invested. There is a tremendous benefit to investing as soon as possible; harnessing the power of time and compound interest.
Unlike simple interest, which is calculated one time solely as a percentage of the principal sum, compound interest is calculated not only on the initial principal but also the accumulated interest of prior periods.
A quick example, if the principal is $100, and the interest rate is 4%, the value at the end of the interest period (e.g. monthly, quarterly, semi-annually, annually) would be $104 (100 x 1.04). However, with simple interest, the interest earned during the first period will not be applied during the second, or any subsequent periods. That isn’t the case with compound interest.
With compound interest, the value at the end of the first period is $104, which now becomes the principal at the beginning of the second period. Therefore, at the end of the second period, the value would be $108.16 (104 x 1.04). With Compound Interest, the growth is exponential because the principal increases each period.
The best way to invest? Opening an IRA account, either a Traditional or Roth. There is no minimum age requirement for opening an IRA account and making contributions. However, the individual must be receiving income from legally recognized employment.
There is no doubt that younger individuals, teenagers or those in their early 20s, would have a difficult time maximizing contributions ($5,500 in 2014) or making significant contributions to their IRA retirement plans. However, there is significant value in building a foundation as soon as possible and developing good personal finance habits.
And even though a young person may not have $2,500 to purchase their first mutual fund (the normal minimal initial contribution), they can always set up automatic monthly contributions between their bank checking account and the financial institution where they have established their IRA account.
The money will be deposited into a money market account, similar to a savings account, until the $2,500 threshold is achieved.
Once reached, the first fund can be purchased. After that, lesser amounts can be used to buy new shares.
If you are a young person that will be working this summer – or you are the parent of a teenager, encourage them to – take a few minutes to open an IRA account and start making contributions, even if it is only $25 a month. Start taking advantage of time and compound interest as soon as possible. Your 60 year-old self will thank you!