Compound interest is “the 8th wonder of the world,” according to financial expert and author Chris Hogan.
The tool that magnifies returns on investments over time truly makes a big difference when it comes to retirement plans. But it requires a strict commitment to avoid one big temptation: cashing out your 401k.
When people prematurely withdraw from a 401k, they’ve “stopped compound interest from happening,” Hogan told Yahoo Finance’s The Final Round. “Compound interest is the eighth wonder of the world.”
“I absolutely love it,” he added. “Your money is growing, when you start to invest in 401ks and Roth IRAs. So we want to leave that money there, allow it to continue to grow.”
The author of “Retire Inspired” — who also advises people to save about 15% of their household income — said that by letting the compound interest do its work, “you're going to be able to know that my nest egg is growing and I'm going to have something to live on later.”
Protecting from ‘a train wreck everyone knows is coming’
Maintaining a well-funded 401k is also a giant safety blanket for those who rely on their Social Security and external sources of income to keep their retirement going.
And with increased strain on the Social Security system, retirees could see a 23% cut in payments by 2034, according to Edelman Financial Services Co-Founder Ric Edelman.
The average retiree receives $1,300 a month in Social Security benefits, so a 23% cut would cut that down to $1,000. That would be burdensome for retirees who depend on that money to make mortgage payments and pay for medications, according to Edelman.
“We now have so many retirees collecting so much money in benefits, and there aren’t enough workers paying taxes into the system to keep it afloat,” Edelman told Yahoo Finance. “This is a train wreck everyone knows is coming.”
‘That’s what America needs to hear’
Compound interest has been hailed as a brilliant and understated tool for wealth generation — the “eighth wonder” quote was apocryphally attributed to Albert Einstein— because it allows money to grow at a much faster rate than simple interest.
But it doesn’t work if one has to constantly dip into a fund in case of an emergency.
Hogan advises that saving for retirement begins only after “you got yourself out of debt and you built up a three to six month emergency fund.”
And with 60% of Americans unable to meet an unexpected $1,000 expense according to a recent Bankrate survey, “there's nothing wrong with getting an extra job to save up to pay cash for something,” said Hogan.
“And that's what America needs to hear,” he added. “You can enjoy some things and have fun, but not at the sake of your financial future. We have to save some money in order to have some to spend later.”
Aarthi is a writer for Yahoo Finance. Follow her on Twitter @aarthiswami.