Welcome back to the Mastering your Money series. Last week we debriefed the importance of budgeting and easy ways to create your own. This week, we are going to look at compounding interest and how important it is to start saving now. Let’s jump right in!
What is compounding interest?
All money that is put into a savings account of some sort will accrue interest over time. Interest is simply the money you are making in return for loaning the bank your money. In fact, the bank only keeps some of your money in reserve and uses the rest to make loans. The interest you receive is almost like a repayment for you allowing them to do so. What makes compounding interest so effective is that you are essentially gaining interest on your interest. Before we dive right into examples, let’s understand the math behind compounding interest.
The formula for compounding interest is simple and in financial terms is called finding the “Future Value” of money. The values in the formula are listed along with the formula below.
The easiest way to find the future value is to google a future value calculator and plug in your values. The more professional way is to plug your values into the formula and use a calculator to solve. The coolest way to do this is to use a graphing calculator. If you use your graphing calculator, use the TVM solver which is located under the Finance section of the APPS button. There you can plug in all these variables, hit APLHA solve on the category you want to solve and you’ve got yourself the ultimate financial cheat-sheet. Whichever you choose, all three are reliable sources to figure out how much your money will grow over time.
Compounding Interest in Action
Now that we understand the math behind compounding, let’s look at some examples. If I were to put $1,000 in an investment account today at an interest rate of 7.5%, I am essentially making $75 in the first year just for letting the bank hold my money. The following year at the same 7.5% interest rate, I am now gaining 7.5% interest on $1,075 and my new earnings are $1,155.63. These gains may appear to be minuscule now, but over the course of a lifetime it will make an astounding difference. Don’t believe me? At the same interest rate of 7.5% you would have made $25,904.84 over a 45-year period without even lifting a finger, but why stop there?
To take even further advantage of compounding interest, add more money to your initial investment and watch your money grow exponentially. Let’s graduate to the big leagues to get a really good idea. Let’s say I invest an initial $10,000 into an investment account at the same 7.5% interest rate for 45 years. This time I am going to make a commitment to save an additional $7,500 annually and put it into my account. Under these circumstances, I would make a whopping $2,231,435.48, allowing me to retire a millionaire. Not bad, huh?
Start Saving Now
You need to recognize the importance of saving your money now. The earlier you start, the more money you will have saved up by the time you want to retire. Unfortunately, so many people today do not have the funds to comfortably retire because of a lack of savings. Many of those wish they would have saved when they were younger and are paying the price now. Trust me, you do not want to be old, tired, and still working to survive. Make the commitment to save today, be disciplined, and your future self will be proud of your current self for taking the initiative.
That’s it for this week’s installment of the Mastering Your Money series. Next week we will discuss what stock is and how to invest in it. Thanks for tuning in, goodbye for now!