Money Earning Money

by Gary Foreman

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I just read your article on compound interest and have a question. I have $25 a week that I can put away for a very long time. Where can I go (bank, credit union, saving and loan, or internet bank) to take advantage of compound interest? Thank you.

Aaron is referring to an article I wrote a few years ago called "Compound Interest for Poor People". In it, I attempted to show how ordinary people could take advantage of compound interest to save money. Before answering Aaron's question, we need to define what compound interest is. And, unlike so many financial concepts, this one is really pretty easy. It's simply earning interest today on the interest you already earned yesterday.

For instance, if you saved $1 and put it in the bank, you'd earn interest on that dollar. If the interest rate were 5% paid annually in one year they'd give you a nickel. If you left the nickel in the account, it would also earn interest in the second year. So next year you'd get more than a nickel in interest. And that's when you're benefiting from compound interest.

A certificate of deposit or other investment vehicle can create compound interest by crediting your account with interest before the maturity date. But Aaron can create compound interest himself, by leaving his interest in the account. The only difference is how frequently the earnings will be credited to his account and begin earning additional interest. All of the institutions that Aaron mentioned will declare interest periodically. It's common to find that interest is declared either daily, monthly, quarterly or yearly.

Naturally, it's better to have the interest paid more often. If you have two CDs that both pay 5%, the one that's compounded daily will earn more for you than the one that's compounded yearly. But, you might argue, it's hard to compare choices with different interest rates and compounding periods. And you'd be right. Fortunately you don't need to be a wizard with a calculator to know how much you're really earning after the effects of compounding are included. Just look at the yield.

Aaron is in a great position to take advantage of compound interest. If he can continue to put away $25 each week, he'll sock away $13,000 in the next ten years. And if he gets a 5% yield on that money it will grow into a nest egg of $16,897. But, that's being very cautious. Certainly CDs are safe. But, if you're saving for the long haul like Aaron, you can get a higher rate of return by buying stocks.

A study quoted by John C. Bogle in his book Common Sense on Mutual Funds showed that stocks earned an average of 10.6% per year from 1926 to 1997. So even including the stock market crash of 1929 the average return is better than CDs. If Aaron earned 10.6% on his $25 weekly savings, he'd end up with an account of $23,168 after 10 years. That's $6,000 more than the CD would have earned.

OK, perhaps you can't save $25 each week like Aaron. That doesn't mean the compound interest won't work for you. Suppose you decided to skip your typical soda with lunch. You save $1. Let's assume that you're 20 years old and you put the dollar away at 5% and the interest is credited once each year. You also leave the interest in the account to earn more interest. By the time you're 65, that single dollar will be worth $9.43. That's the magic of compound interest.

Still not impressed? Suppose that you skip the soda every work day this year. You'd save $250 on unpurchased sodas. Even if you never added another cent after this year, when you're 65 you would have an account worth $2,358. Let's take it a step further. If you got the 10.6% yield the single dollar would become $102 when you reached age 65. Better still, if you skipped a soda a day until age 65 that would grow to $240,000. That's a lot of money for such a small lifestyle change.

Please notice the dramatic difference. It's caused by the effect of compound interest being magnified by the higher yield. The point is simple. If you can put the savings away for a number of years you'll do much better by choosing a quality stock mutual fund instead of a bank or credit union.

There's also a sinister side to compound interest. If you borrow money, it's important to make payments at least as great as the interest owed. Otherwise you're going to be charged interest on the interest that you didn't pay.

OK, let's summarize. Compound interest is a marvelous tool for saving money. It works well for small or large amounts of money. Compound interest magnifies any increase in investment return. The effects of compound interest get larger as time goes by. You can earn compound interest anywhere as long as you allow your earnings to be reinvested. Aaron is off to a great start. And with the help of compound interest he's likely to accumulate a nice nest egg over the years.

True or False

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Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.

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