You work hard for your money and once you put it into savings, it starts to work for you.  Compound interest is the idea that over time interest is added to your initial investment amount and each year you earn additional interest on that as well as your initial investment.  While a simple concept, it’s very powerful for growing your money over time.  So if you invest $100 in an account paying 10% a year in year 1 you would earn 10% on $100, or $10.  Then in year two, you would earn 10% on $110, or $11. And so on.  Your money is working for you.

To see the value of compounding interest in action and what a difference a few percentage points of return can make over the long haul, consider an an investment of  $100 made for 10 years.  If your investment returns 10% over the time period, you will have $2,564 in the end, whereas if your investment returns 5% over the time period, you will only have $1,610 at the end of 10 years. The formula for calculating simple compounding interest if you want to do it yourself, is as follows:

Total = Principal * (1 + interest rate) ^ # of years of your investment

Thinking about compounding interest is good motivation for saving as much as you can early on, and also for making sure your money is working as hard as it possibly can, where ever you have it invested.

Save Early

The earlier you start saving, whether it be for retirement or college for your kids, the more time your money will have to grow.  This means you can either save less over time or you can afford to take less risk with the money you do save. Say your goal is to have $1,000,000 by the time you retire, you start with nothing, and you assume your investment will return 8% over time.  If you start saving at age 25 you need to save $308/month to reach your goal.  However, if you don’t start saving until you are 45, you will need to save $1,746/month to have $1,000,000 by age 65.   Here is a savings goal calculator so you can do your own calculations.

Optimize Your Accounts

In the investment world there is a trade-off between risk and return.  Typically, to earn a higher rate of return on your money over time you have to take more risk with your money.  However, having your money work hard does not necessarily entail taking more risk, it can also mean making sure that your savings account is earning the highest interest rate possible or that your S&P 500 index fund has the lowest fees.  The difference between earning 0% and 1% on a $1,000 initial investment equates $488 over a 40 year time frame.  This 1% is magnified as you start to talk about investments with higher returns.  If you can lower your fees by 1% and thereby earn 8% over the life your investment rather than 7%, you earn $6750 more on your $1,000 over 40  years.

The concept of compounding interest is what motivates me to max out my retirement accounts today even though I’m more than 30 years away from retirement and save for our kid’s education even though it is 17 years off or more.  It also motivated me to recently move our money that we have in a savings account from a brick and mortar bank where it earned almost nothing, to an ING online account where it earns 1% or more.  While 1% is still an anemic rate, it allows our money to grow over time, whereas at our other bank it was earning nothing.

Compounding interest is one of the building blocks of almost all personal finance.  If this is a new concept for you, welcome to the world of having your money work for you.  If you’re an old pro at the concept of compounding, hopefully this post provides you with some motivation to go through your savings and investing plans and make sure you are saving as much as you can and that the money you do save is as optimally invested as possible.

 

*Photo by jswieringa

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