Finding Compound Interest
by Gary Foreman
The Power of Compound Interest
A Little Difference
Compound Interest for Poor People
Compare CD Rates
I have read and heard about compound interest as a sound tool for saving. Other than the measly interest that you get from banks and some credit unions, I cannot locate an institution that offers such a thing. Are you allowed to recommend organizations that offer good compound interest programs at high interest?
Jennifer understands the value of compound interest. And, she's right to want to use it to build wealth. But let's review for those who aren't that familiar with it.
Compound interest is really pretty simple. If you loan money, you expect to earn a specific amount of interest over a specified time (for instance 4% per year). Suppose that you leave the loan open for a second year. If your loan were earning "simple" interest, it would earn the same rate and amount as the year before.
But, in a compound interest loan, instead of taking the interest you earn, last year's interest is left with the original principal. The new interest owed is calculated on that sum. So you're also earning interest on last year's interest. And, that's "compound" interest.
The concept is best discovered at an early age because the results are most impressive after long periods of time. A dollar saved in your 20s is much more valuable than one saved in your 50s.
Let's look at an example. We'll suppose that Jennifer had $1,000 in savings and that she earned 4% on it annually. Further, let's say that she left it in the bank for 50 years at the same 4% rate and that the account wasn't compounded. At the end of the 50 years, she'd have $3,000 (the original $1,000 plus $2,000 in interest earned).
That example isn't completely realistic. Very few people would leave money in a simple interest account for 50 years, but the example is instructive because we're going to compare it to the results earned by compound interest.
So what happens to our example if the interest is earned and compounded annually. Jennifer's $1,000 becomes $7,106 in 50 years. You wouldn't think that earning 4% interest on a measly $40 could make such a big difference. But it does. The interest earned the last year alone is $273. Thank you compound interest!
What about timing? At the end of 30 years, the $1,000 had only grown to $3,243. That means that about 63% of the increase takes place in the last 40% of the time. So the sooner that Jennifer gets going the better.
Now to the meat of Jennifer's question. Where can you earn a good compound rate of return? She's right. Bank rates aren't that attractive. But, in fairness to them, they do guarantee that you can't lose any money.
So where should Jennifer look? The first place is to other banks. Banking has become more competitive. Another bank may offer an account (and interest rate) that's better for Jennifer.
It's also possible that she's getting the benefits of compounding without realizing it. Consider a mutual fund account. If you automatically reinvest any dividends, interest or capital gains, then it's the same as getting compound interest. Technically, it may not be called interest, but the money spends just fine!
We don't have the time to discuss it here, but for long-term investing, a basket of common stocks have always performed well. Even if you happened to buy right before a market crash (like 1929). Some experts are predicting that future returns won't be as good as past performance, but even they expect an annual return in the 6% or better range.
If we put Jennifer's $1,000 to work compounding at 6% annually, it will grow to $19,935 after 50 years. Not bad for a one-time investment of $1,000.
We won't try to pick a mutual fund for Jennifer. Unfortunately, a single email from her can't provide enough personal information to allow for good advice in that area, but that shouldn't prevent her from finding one herself.
She can find an introduction to funds from the Securities and Exchange Commission at sec.gov/investor/pubs/inwsmf.htm. Comparisons are available at kiplinger.com and other magazines and websites. Look for well established no-load funds with a long past record of success.
Here are two final thoughts. It's also important to realize that compound interest can work against you. Carrying a balance on your credit card is a good example. So the first way to take advantage of compound interest is to pay off any credit card balances you're carrying.
Finally, we should note that compound interest is nothing new. In fact, Ben Franklin promoted it centuries ago. In his will, he left $5,000 each to the cities of Boston and Philadelphia. Each city was to have a fund that would last for 200 years. The money was to be loaned to needy young people at 5% interest. After 100 years, each city could withdraw $500,000 from the fund, leaving the rest to work for the second 100 years. The cities managed to deviate a bit from Franklin's plan, but they did clearly demonstrate the benefits of compound interest.
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Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and CreditCards.com. 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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