Saving money can be a daunting task. Putting money away each month and not knowing what happens to it is often a thought that crosses new investors’ minds. With an early start and contributing to a savings plan, you can get ahead with your savings goals.
Starting with your savings early enough is advantageous to you over a long period, as you benefit from compound interest. By compounding your money, your money will grow far beyond what you originally invested.
So, what precisely is compound interest, and how does it work?
What is Compound Interest?
Compound interest is often called the eighth wonder of the world, and we choose to agree with this statement! With compound interest, your interest earns interest.
Your initial investment will earn interest, and whatever interest your investment makes, that will earn interest, too.
Compound Interest vs. Simple Interest
You might have also heard of simple interest, which differs from compound interest. You calculate simple interest from your initial investment amount and any future deposits only. Any interest you earn on this investment will not earn interest, so there are no benefits as with compounding.
Using compound interest helps you visualize your future savings, and therefore allows you to plan for the future. Set some goals for retirement and other short-term goals – like saving for your wedding – and how much you need over a certain period, and you can calculate how much you need to contribute to reaching these goals.
A Compound Strategy to Follow
When you start investing, you want to know how to plan. Follow this simple compounding strategy to reap the rewards.
Start Saving Early
By starting early with a small contribution, you can enjoy the power of compounding over the long term. It’s never too late to start with investing, but the younger you are, the more significant your investment will be.
Simply put, the longer your money stays invested, the longer it has time to grow. Time is your friend with compounding.
Make Regular Contributions
No matter what amount you can afford to invest, the essential thing to remember is that you need to start right now and be consistent with your contributions. You don’t need to be rich to start investing, so plan your budget and determine how much you can afford with a monthly contribution.
If you’re afraid you will fail and forget about your contributions, consider setting up a monthly automated contribution from your bank account. This will allow the contributions to leave your account before you get to spend it.
Don't Touch Your Investment!
You might get tempted to withdraw from your investment when you see how well it’s performing and growing. Remain disciplined and leave your investment alone!
You will build wealth as your savings grow and earn a compound return. The more time you leave your investment alone, the more time you give your money to grow. Remember, time is on your side!
Compound Interest Calculation
There are numerous compound interest calculators that you can find online. But let’s look at an example of compounding’s power by using the calculator to determine the returns on investment throughout 1, 5, 15, and 30 years.
Let’s say you can afford $150 per month, and you invest the money with an annual interest rate of 6%.
After 1 year:
- Total investment account balance – $1,850.00
- Interest earned – $50.00
After 5 years:
- Total investment account balance – $10,465.50
- Interest earned – $1,466.00
After 10 years:
- Total investment account balance – $24,581.90
- Interest earned – $6,582.00
After 30 years:
- Total investment account balance – $150,677.26
- Interest earned – $96,677.00
With a small monthly contribution and an average annual interest rate, you can see how compound interest can work for you and your money. Never think it’s too late to start investing! Every year your money gets to grow, you are one step closer to reaching your goals.
Compounding Can Work in Reverse
Unfortunately, compounding can work in reverse, which is never a good thing. Your personal debt, such as credit cards or car loans, can have you paying back in compound interest if you skip contributions.
If you miss your credit card payments, the interest you owe will start to compound each month. In return, you will end up paying back a lot more money than you would have thought and could become difficult to pay off.
The Rule of 72
To quickly estimate how long you need to double your investment with compounding, you can use the rule of 72. The formula is merely dividing the number 72 by the yearly interest rate you intend to earn on your investment.
The rule isn’t always precise, as it only works with interest rates lower than 20%. If the expected interest return changes, the time to double your investment may change, especially if the investment return isn’t guaranteed.
Let’s look at an example:
If you’re expecting an annual return of 6%, you will double your money in 12 years if you leave your money to compound. By using the rule of 72, you will divide 72 by 6 to get to 12 years.
Where to Start Saving
If you’re unsure where to invest, consider a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA).
Both savings accounts don’t require you to be rich to invest, so you can start your journey today by earning compound interest and reaching financial freedom.
Compound interest can boost your investment returns, especially if you can invest more significant amounts. But don’t let it deter you, as every amount saved will work for you over the long term.
Time is on your side and is one of the most critical aspects of compounding, as the longer you can leave your money to grow, the more you can expect in returns.
Even though compounding is to your advantage, it can work against you if you have debt and struggle to pay it off. Make sure all your accounts are up to date, and you won’t have to sit with compounding interest working against you.
Start compounding today, and make it work for you!