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Compounding Your Interest: How To Increase Your Saving’s Return
by Dr. Scott Brown, Advisory Panelist
Tuesday, March 17, 2009: Issue #957
One of the most pervasive answers I hear about why people aren’t saving more, is that savings “just sit there.” They don’t do anything. With the many classes and the lectures I do, it never ceases to amaze me when I hear that.
And while other excuses run the gamut from the high cost of living to sheer apathy – the fact is, most Americans don’t really understand saving. Many believe that it’s just too risky to put your money in the market right now. On the other hand, if it’s in a CD, money market or savings account their money isn’t doing anything.
They aren’t too far from the truth.
Even the best interest rates on cash are yielding less than 2.5%. And while inflation has been down in January, it’s averaging over 3% for the last 12 months.
But right beneath our common savings misconceptions is the very way we can do it better. There is a way to double the return on your safest accounts – without increasing your risk. By reinvesting and compounding your interest, you can double your returns. Here’s why more investors need to understand compounding.
Compounding Your Interest – How To Grow Your Savings
Many know that they can grow their savings with simple reinvesting and compounding your interest.
But how much more… you might be surprised.
The amount of interest earned on a $1,000 savings deposit over five years that compounds annually at a 5% rate is $276. But if we compound it for another five years that same account grows at more than twice the amount earned after the first period. It’s earned interest of $629 instead of $276.
Why the big difference? It’s because of compounding.
Compound interest is literally interest on interest. So, after one year you earn $50 in interest (5% X $1,000); after two years you earn another $50 in simple interest plus $2.50 in compound interest (5 % X $50); after three years, you earn another $50 in simple interest plus $5 in compound interest (5 % X $100), on and on.
Simple interest is the amount of interest earned on the original principal, while compound interest is earned off the reinvested interest.
The Raw Power of Compounding Your Interest
Over many years the raw power and impact of compounding your interest is huge…
It doesn’t sound like much but a husband and wife contributing $5,000 each to a retirement or savings account would have $50,000 in five years and $100,000 in 10 years.
But with a return of just 5% it would grow to $68,019.13 in five years, and $142,067.87 in 10. That’s $42,067.87 of interest in just 10 years – and more than double their $18,019.13 five-year interest earnings.
The more frequently interest is compounded the higher the effective rate. You end up making more interest!
Now, imagine that a husband and wife saved up for 10 years starting at age 30 at 5% in two Roth IRAs and stopped contributing at age 40. They just let the $142,067.87 sit and compound for another 25 years until they retire at age 65.
That pile of cash would grow to nearly half a million…
Compounding Your Interest – Watch The Rising Interest Rate
But the interest rate would also be higher the more you compound. See in the table below, where FV represents future value.
You should be interested not only in the nominal or stated rate of interest, but also the effective rate.
The effective rate of interest is the interest actually earned for a period of time, based on both the nominal rate of interest and the number of times it is compounded annually.
Compounding your interest is an easy way to increase your savings’ return and should give you fewer excuses why you aren’t saving.
And the sooner you start, the larger your returns will be.
While we’re going through more than a rough patch in our economy, it doesn’t mean we should stop good habits that will eventually make us millionaires. Let compounding do the work for you.
It all starts with education,
Scott Brown
Today’s Investment U Crib Sheet
Last month, Scott Brown gave us Financial Stability: 4 Steps to get Your Finances in Order because as many know, it’s not as easy as it sounds to be fiscally disciplined. But it’s worth the difficulties. It’s why we do what we do here at Investment U. In addition to helping our readers become better investors, we aim to provide a range of investment options and ideas.
Just last week, Scott showed us why ETFs are becoming a growing part of many investors’ portfolios – helping to reduce costs and provide diversification. You can read more on Exchange Traded Funds: How to Put Your Mutual Fund on Steroids and why you need to see if ETFs are right for your portfolio.
Lou Basenese showed us the “ins and outs” of the mark-to-market rule, and how it is affecting the investments around the world. But its affects can also mean undervalued assets begging to be bought.
Compounding doesn’t just work in savings and cash accounts. Stocks show some of the most powerful effects of compounding, especially those that give out healthy dividends. In fact, we just discovered a dividend producing company with a virtual monopoly on their market.
- The Paradox of Thrift: How a Better Savings Rate is Fueling the Recession
- Smart Investing: Paying Yourself First
- The Forex Markets: A Rare Glimpse Into The World of Forex Trading
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13 Responses to “Compounding Your Interest: How To Increase Your Saving’s Return”
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Dr. Brown specializes in teaching stock investing because as he emphasizes "the stock market is where individuals and families have the best shot at succeeding financially!"
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March 17th, 2009 at 9:46 am
Mr. Brown,
Your article and points made are correct… in theory! Yes saving is fundamental imperative. But how one can be convinced especially after this colossal collapse of the market where all this compounding fundamentals just flushed down the toilet?
There are no simple saving options to take advantage of such simple math. As you pointed out CD accounts at best match up with the inflation (and we haven’t talked about taxing the interest). On the other hand investing in an IRA (either Roth or regular) has the volatility effect (fees, expenses, etc). So one cannot trust that in a 10 or 25 years period they will get to the point where compounding made a big impact. I think on the contrary, those who primarily save like that (me included) are the ones who get hurt the most…
I would expect at the end of such an article, that you backed up your story with examples of investing options (i.e. names of funds, ETF’s, etc) which if analyzed, will prove to be aligned with your theory.
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March 17th, 2009 at 10:08 am
THANK YOU FOR IT WAS REALLY AN EYE OPENER.
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March 17th, 2009 at 10:17 am
Where do you sugest one finds a bank that gives 5%?
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March 17th, 2009 at 11:13 am
But in most situations, in Canada at least, one is taxed on the interest annually, even though one hasn’t “withdrawn” it. That takes the gilt off the gingerbread, I think. Only in a retirement account might that not be the case.
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March 17th, 2009 at 12:29 pm
Funny, I always hear about compounded interest and I never hear about compounded profits… even better, in a tax free account…. Wonder why….
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March 17th, 2009 at 1:09 pm
yes its true with 5% compound interest you earn that money, but you, forget the yearly inflation which is about 3% you just finished with only 2% with the cost of living going up everyday its not enough, on the other hand today you dont have to trust nobody.Its not worthit invest your money with the banks anymore when the ceo get millions of pounds from you and everybody lossing their funds thank ??????
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March 17th, 2009 at 8:26 pm
I am 50 and want to start putting $200/month into Franklin Gold Fund…9.85% yield. Shares around $25. Reinvesting the yields and buying more shares with the reinvested can you tell me roughly what that would be worth in 5 yrs…10years? Thanks
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March 17th, 2009 at 8:41 pm
But where to get that 5% rate? The best thing I have found locally are “rewards checking” accounts paying 5% interest on deposits up to $25K. They require at least one automatic deposit monthly, 10 debit card transactions per month, and provide only on-line statements to get the rate. The money is liquid. The downsides are lowered interest rates whenever the bank decides and the need to monitor usage of the debit card to meet minimums. My original checking account at the local credit union went from 5% initially in Oct 08 to 4.75 in Jan & Feb 09, and 4.5% in March. I found another bank offer with similar requirements and we’ll see how long the great rate lasts.
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March 17th, 2009 at 9:37 pm
Gday everyone, the best interest rates that I am aware of in the world are: http://www.bankwest.com.au KIDS SAVER ACCOUNT Paying 10% Interest calucated daily (Paid monthly. Operated by Bankwest In Perth, Western Australia (All deposits guaranteed by Australian government against losses) Possible witholding tax for Non Australian residents…
Or http://www.hsbc.com.tr was paying 16% before crisis, now paying 11%. operated by HSBC in Turkey, guaranteed by UK Government against losses..Its in there currency, but you can switch back to USD OR GBP accounts, when you want your money back..Or if you are planning to buy a holiday house in turkey as they are still a bargain, its a great way to save…Of course do your homework…And good luck investing Cheers…
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March 18th, 2009 at 4:43 am
Excellent article, the obvious is not so obvious to many. Did you know that some banks and credit unions are offering current interest rates of 4% (or more) for doing direct deposit, mostly on-line banking and using a debit card vice checks for many transactions (about 12 per month).
r/ Gerry
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March 18th, 2009 at 7:38 am
It also works in the opposite way. Interest on debt. such as we are going to see in the near future to pay for all this mess. That is unless we just print our way out of it, which will make our purchasing power go down and the dollar worth less.
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March 19th, 2009 at 1:52 am
Investing 101, but it’s so powerful… and really should be taught to every grade 12 student before they graduate.
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March 21st, 2009 at 12:18 pm
5% interest sounds terrific. Please tell me where I can find it.
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