Here Is How Compound Interest Explodes Your Savings
Compound Interest Is Your Financial Partner
Knowing how compound interest functions can allow you to pick out a savings account or an investment account where your money will work well for you. If your money earns compound interest, your savings will grow significantly faster, so you can reach your goal more quickly.
- Compound Interest Basics
- The Compounding Effect
- The Cost of Delaying Saving
- The Compound Interest Formula
- Effective Interest Rates
Compound Interest Basics
Simply put, compound interest is interest that is paid on both the initial principal, as well as the interest you accumulate on any money that you've borrowed or invested. When it comes to savings, compound interest is the best of the best. You'll earn interest on the money that you save, and then you'll earn interest on top of that, meaning your money grows even faster. An online savings account that pays you interest monthly is a great example of an account that will earn you compound interest. If you leave the money alone, the balance will grow slightly each month, and then you'll earn interest on the new amount. If you add to it, this effect only increases.
Simple interest is good, but it's not nearly as exciting. With this type, interest is paid out only at the end of a pre-determined period of time. A term deposit is one type of account that earns simple interest. Others earn interest every twelve months. Either way, you earn interest, but it just doesn't grow as quickly.
Make Compounding Work for You
If you invest $10,000 at 5% per year, for five years, with the interest paid at term's end, you'll earn $2,500 in simple interest when the five years is over. This is a total of $500 each year. After five years, you'll have $12,500.
If you invest the same amount of money with your interest added monthly, you'd earn $2,834 in compound interest, and after the end of your five years, you'd have a total of $12,834. You'll have earned over $300 more in five years, by earning interest on your interest.
Compound interest grows each year and allows your money to grow more quickly. It's simple math, but it makes a world of difference when you're saving for something important.
Not all banks handle investments in the same way. Some compound your interest monthly, others each quarter, others annually. Some banks charge you fees, others do not.
It's important to read the fine print, take all of this into account, and be sure that you understand all of the terms of your account.
You'll receive a statement monthly, and yearly, comparing your balance and showing you any increases or decreases as well as your interest rates. Use this information to make sure that your money is always working as well for you as possible.
The Compound Interest Formula
Educate yourself about the investment rates for your accounts and investments, and how they calculate interest so that you are well informed about what your money is doing at all times.
Otherwise, you could be losing money each month in missed opportunities, and you may not be able to make up the amount by saving more in the future - especially if you take compound interest into account.
Compound Interest Formula *
Compound interest can seem complex, and the formula isn't extremely simple, but the process is straightforward.
The formula is A = P x (1 + r)n
A is the total amount of your investment at the end
P is the principal or the starting amount of your investment
r is the decimal expression of the annual interest rate (5% would be .05)
n is the number of time periods
Example 1 - Compounded Annually
What will the total be after investing $5,000 for 3 years at a 4% rate, compounded yearly?
A = P x (1 + r)n
A = 5000 * (1.04)3
A = 5000 * 1.124864
A = $5624.32
Example 2 - Compounded Monthly
What will be the total be after investing $5,000 for 3 years at a 4% rate, compounded monthly?
For this, you'll need to divide the annual interest rate into a monthly interest rate, by dividing by 12. So .04% becomes 0.0033%. You'll also need to know the number of time periods, which is months. Three years at 12 months a year is 36 months.
A = P x (1 + r)n
A = 5000 * (1.0033)36
A = 5000 * 1.12592
A = $5629.6
Effective Interest Rates
Different financial institutions treat investments differently. Some will compound monthly, quarterly, or annually. Fees, too, need to be taken into consideration, as some will charge fees, and others will charge higher, lower, or no fees.
Luckily, there is a shortcut to understanding every institution's different policies: APR. The annual percentage rate, or APR, takes all these factors into account and provide a simple interest value.
This is calculated by looking at the balance at the close of a year and comparing it to the balance at the opening of the year. The increase is then presented as a percentage of the value at the beginning of the year. This effective yield is the rate you would have had to get that same ending balance if you ignored compounding interest and had no fees.
This allows you to use the APR to compare various account and investment offerings on a fair basis, to understand what options you have available.
It can be tempting to delay saving and then attempt to make up the difference down the road. Let's look at a case study to see what happens in this situation.
Richard and Lee's saving strategies
Richard deposits $1,000 into a high interest savings account and then saves $100 per month for 10 years at 4.5% interest compounded monthly.
Lee isn't able to start saving for 5 years but then doubles her savings compared to Richard, at $200 a month at the same bank at the same rate and compounding.
Richard started saving earlier, at a more modest rate and was able to get compound interest working for him. This benefited him significantly in the example and will continue to work for him in the future.
The Result After 10 Years
> Richard will have saved up $16,687
> Lee will have saved up $14,681
It’s important to start saving as soon as you can to reach your goals. In some cases, you might still not be able to catch up to people who started saving a few years earlier than you, even by doubling your investment.