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 20's is
much more valuable than one saved in your 50's.
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
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.
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.
Gary Foreman is a former financial planner who currently edits The Dollar Stretcher.com website and newsletters. If you wish you had more time or
money you'll want to visit today.