Saving money can be a daunting task. Putting money aside each month and not knowing what will happen to it is a thought that often crosses the minds of new investors. By starting early and contributing to a savings plan, you can get a head start on your savings goals.
Starting to save early is beneficial over a long period of time because you benefit from compound interest. With compounding, your money grows far beyond what you originally invested.
So what 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 agree! With compound interest, your interest earns interest.
Your initial investment will earn interest, and any interest earned on your investment will also earn interest.
Compound interest and simple interest
You may also have heard of simple interest, which is different from compound interest. You calculate simple interest from the amount of your initial investment and any future deposits only. The interest you receive on this investment will not earn interest, so there are no advantages like with compounding.
Using compound interest helps you visualize your future savings, so you can plan for the future. Set goals for retirement and other short-term goals – such as saving for your wedding – and determine how much you need over a period of time. You can then calculate the amount you need to contribute to achieve these goals.
A compound strategy to follow
When you start investing, you want to know how to plan. Follow this simple capitalization strategy to reap the benefits.
Start saving early
By starting early with a small contribution, you can harness the power of compounding over the long term. It’s never too late to start investing, but the younger you are, the bigger your investment will be.
In other words, the longer your money stays invested, the more time it has to grow. Time is your friend with capitalization.
Make regular contributions
No matter how much you can afford to invest, the key thing to remember is that you need to start now and be consistent in your contributions. You don’t have to be rich to start investing, so plan your budget and determine how much you can afford with a monthly contribution.
If you are afraid of failing and forgetting your contributions, consider setting up an automatic monthly contribution from your bank account. This will allow contributions to leave your account before you can spend them.
Don’t touch your investment!
You may be tempted to pull out of your investment when you see its performance and growth. Stay disciplined and don’t touch your investment!
As your savings grow, you’ll get richer and enjoy a compounded return. The longer you leave your investment alone, the more time you give your money to grow. Remember that time is on your side!
Compound interest calculation
There are many compound interest calculators that you can find online. But let’s look at an example of the power of compounding by using the calculator to determine the returns on investment over 1, 5, 15 and 30 years.
Let’s say you can afford $150 a month and you invest that money at 6% annual interest.
After 1 year:
- Total balance of investment account – $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 income – $6,582.00
After 30 years:
- Total investment account balance – $150,677.26.
- Interest earned – $96,677.
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 that your money grows, you get a little closer to your goals.
Capitalization can work in reverse
Unfortunately, capitalization can work in reverse, which is never a good thing. Your personal debts, such as credit cards or car loans, can cause you to pay compound interest if you fail to contribute.
If you miss your credit card payments, the interest you owe will start to accumulate each month. In return, you will end up paying back a lot more money than you thought you would and it could become difficult to pay back.
The rule of 72
To quickly estimate how long you need to double your investment with compound interest, you can use the rule of 72. The formula is simply to divide the number 72 by the annual interest rate you expect to earn on your investment.
The rule is not always accurate, as it only works with interest rates below 20%. If the expected return on interest changes, the time to double your investment may change, especially if the return on investment is not guaranteed.
Let’s take an example:
If you expect a 6% annual return, you will double your money in 12 years if you let it grow. Using the rule of 72, you will divide 72 by 6 to arrive at 12.
Where to start saving
Compound interest can increase your investment returns, especially if you can invest larger amounts. But don’t let that discourage you, because every amount you save will serve you in the long run.
Time is on your side and is one of the most important aspects of compounding because the longer you can let your money grow, the higher the return you can expect.
Even though compounding works to your advantage, it can work against you if you have debt and are having trouble paying it off. Make sure all your accounts are up to date and you won’t have to suffer the effects of compound interest.
Start composing today, and make it work for you!