11/19/2012 8:00 PM ET|
10 facts about compound interest
To concept is simple, but the rewards can be huge. If the interest you earn on your savings earns further interest, money grows quickly.
When Benjamin Franklin died in 1790, he left $5,000 each to the cities of Boston and Philadelphia. Each city was to create a fund that would last for 200 years. The needy could borrow from the fund at 5% interest. After 100 years, each city could withdraw $500,000 from the fund, leaving the rest to work for the next 100 years. Why did Franklin do it? To help people understand the importance of compound interest.
What is compound interest? It's interest earning interest. Suppose you banked $100 a year ago, and it has since earned $2 in interest. This year, you'll be earning interest on $102 (original savings plus the interest earned). That might not seem like much, but understanding that simple process can have a major impact on your financial success.
Why is compound interest so important? Because it can turn just a few dollars today into big money over the course of a lifetime. Here’s a look at 10 things you need to know about compound interest:
1. Anyone can benefit from compound interest. There’s no need to be a Wall Street wizard or a Harvard MBA. Almost any investment will earn compound interest if you leave earnings in the account.
2. Compound interest is a double-edged sword. It's great if you're routinely saving money, but it can be cruel if you're borrowing money.
3. You want savings to compound as often as possible. It's better for your savings to compound quarterly than annually. If you're borrowing, just the opposite applies.
4. For savings, time is on your side. The longer money compounds, the faster it grows. Money growing at 6% per year will double in about 12 years, but it will be worth four times as much in 24 years.
5. For debts, time is not on your side. Credit cards and other open-ended accounts use compound interest against you. That's why making only minimum payments is likely to keep you in debt forever.
6. Today's low interest rates shouldn’t discourage you. It's true that banks aren't paying much on savings accounts these days. But many mutual funds average a higher return and have very low minimums and no sales charges. If you can't tuck away a few dollars a month in savings, try paying down what you owe faster. Most debts (think home loans or credit cards) will allow you to add any amount above your minimum payment.
7. It adds up faster than you think. If you were to save $5 per month for 10 years, you'd have put $600 into savings. But if you were to earn 5% interest compounded each month on that account, your savings would be $776 at the end of that decade. And even if you didn't add a single dime after that, 15 years later, the account would be worth more than $1,500.
8. Compound interest can free you from credit card debt. Suppose your interest rate is 14% and you add just $5 per month to your payment. In 10 years, you will have avoided $1,315 in payments.
9. You don't have to be rich to make compound interest work for you. The principle works the same whether you invest $100 or $100 million. A millionaire may have more investment options, but even if you have only a modest income, you can use compound interest to build a bigger nest egg or reduce the amount you pay credit card companies.
10. With compound interest, the sacrifice is smaller than the benefit. To save a few dollars today, you’ll have to say no to some purchases. But it's certain that the future reward will be greater than the sacrifice.
The bottom line for consumers: Often the difference between financial comfort and poverty isn't that great. Saving a few dollars a week might not seem like much, but if you do it consistently, you could be making a big difference in your financial future.
More from U.S. News & World Report:
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Savings earn further interest, money grows quickly? I don’t think is going to happen. Because when I look at the bank, the interest is still slow, not that fast.
Don't get so overhyped about semantics, folks. This article is not recommending PRODUCT, it's recommending you take advantage of compounding. Very sound, based upon math alone.
Don't forget about "not keeping all your eggs in one basket". If the only place you put money is in the bank, you'll eventually lose out to inflation. If the only place you put it is in the market, you risk a 2008 scenario with an average drop of 38%--not good if you need to retire soon after. And for the love of Pete, DO NOT confuse rate of return with interest, as they are vastly different things. Interest is a known figure ahead of time, and rate of return can only be known after the fact, when it's too late to change your mind.
Bank accounts, Mutual Funds, permanent life insurance, stocks, bonds, annuities. If possible, ALL should be in the plan because no matter what's happening in the economy at any given time, some of those are doing well and offsetting the ones that aren't.
Most importantly, you have to actually put the money away. A ten thousand percent rate of return on zero dollars still leaves you with zero dollars.
The Fed is giving the banks money for .025 and then they buy Fed bonds at 2% interest. Now that is compond interest!! Thanks tax payers.
This is the usual bs. Where do you get 5% compounding anymore? You have to put money in the market and that is now no different from playing the slots. The banks need to be regulated alright and they need to start giving real interest again...they give nothing but if you borrow, they charge a fortune. The mob would probably offer a better rate.
Thank God for FDR and Social Security and the results of the election. We shouldn't hear any more about "privatizing" Social Security, which is not an entitlement program and which, if they do nothing, is solvent until the mid-30s and with minor adjustments will last probably through the end of this century.
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