Growing Money - Compound Interest

Have you ever had to save your money in order to buy something in the future, perhaps a new bike, a video game, the latest electronic device or your college education? Has anyone ever told you “Money doesn’t grow on trees”? While it’s true that money doesn’t grow on trees, it does grow—and beginning to save some of your income now, can pay off for you in a big way as a result of compound interest.

Before I explain how compound interest works, let me explain what interest is. Interest, is the price people pay for the use of someone else’s money. Interest is often expressed as rates or as a percent.

Here’s an example, meet Pat. Pat needs to borrow $5,000 to buy a used car. Are you enjoying the open road? Pat will have to pay back more than $5,000 to the bank over the life of the loan. How much more will Pat pay back? It depends in part on interest rate—the price bank charges for the loan —maybe 5%. In this case, Pat is paying to use someone else’s money. On the other hand, if Pat put $5,000 into a bank account or certificate of deposit, Pat is lending money to the bank or financial institution, and they must pay Pat. How much additional money will Pat earn over the time this money is deposited? You guessed it, it depends on the interest rate.

You will find the interest rates you pay when you borrow, and receive when you save, depend on the level of risk. Risk is the uncertainty that the lender will be repaid. When you lend money to a bank or financial institution through your deposits, your risk is pretty low. Deposits at banks in the U.S. are insured by the Federal Deposit Insurance Corporation, FDIC, and at credit unions; deposit insurance is administered through the National Credit Union Administration, NCUA. While subject to certain terms and limits, your money is very safe in a savings account—almost risk-free. Because there is little risk, the interest rate you receive from a bank is relatively low. When you borrow money, the bank or financial institution takes the risk that you’ll be able to repay the loan. The interest rate you pay is a function of the risk that you will default, or not be able to make the payments. Remember, higher risk means higher potential rewards, but it also means higher potential for loss.

Compound interest, or compounding, means that interest is earned on the amount you initially deposit—what we call the principal—and on the interest you earn.

Now that you know what compound interest is, let’s talk about how it works. Let’s assume that Erin is 17 years old, and has saved $1,000 from a part-time job this summer. Erin puts that money—the principal—into an account at the local bank that pays 3% interest compounded monthly, beginning today. With no additional deposits, in 20 years Erin’s balance would be $1,820.75. That’s not bad for adding no additional deposits, but what if Erin did?

Let’s start with the same initial investment of $1,000, but this time, assume Erin deposits an additional $50 per month—that’s only $12.50 per week. In 20 years Erin would have $18,235.85.

If you do the math, you’ll see that Erin put $13,000 of her hard-earned dollars into savings. Compound interest will have paid the remaining $5,235.85. Now, I know this might be hard to imagine, but think about that same initial $1,000, and only $50 per month for 50 years when Erin retires at age 67. Erin will have “paid in” $30,950, but will enjoy a balance of $73,939.46.

This looks pretty good, doesn’t it? Well, it could get better—watch this.

Let’s change one variable and see what happens. Instead of 3% interest, let’s assume Erin takes on a bit more risk with an average of 5% return over the next 50 years. With everything else the same, that $73,939.46 would be $145,551.98! But remember, the principal is still the $30,950 we talked about earlier.

But you say, “Wait!” I can’t afford to save that much for retirement. “I have to save for college and a car!”

I understand, but don’t wait too long to start. Here’s why:

Say Erin put off saving until age 30. At that time, Erin puts $50 per month into a retirement account. From age 30 to 67, Erin will still earn compound interest, however, even at the higher 5% rate of return, Erin will have a much smaller account balance $70,360.49. The 13 years of compound-interest income Erin didn’t receive—what economists call the opportunity cost—amounts to $75,191.49! Not exactly pocket change!

This illustrates an important point about taking advantage of compound interest: it’s not just how much you save, but when you start that will help your money grow … so start early and save often.

As you’ve seen, there’s no secret fertilizer required to “grow money” only self-discipline and the power of compound interest working for you. All you have to do is put your savings in an interest-bearing account, leave it there and make regular contributions. Remember to pay yourself first—have the money directly deposited from your paycheck each pay period or treat the payment to your savings account like a bill you pay to yourself each pay period.

With planning and disciplined savings, you’ll see that while you don’t have a tree that’s full of money, you just may have a retirement account that is.

In the next episode of No-Frills Money Skills, we’ll dig into different ways to save, including how tax laws and some employers help people prepare for their retirement.

I’m Kris Bertelsen and I’ll see you next time.