Let’s pretend you had $1,000 in the bank, and it was earning 1% interest.
Fat chance, eh? In these days of rock-bottom interest rates on savings accounts, you’re doing pretty well if you get a whole 1% interest. But this story is all about compound interest and how it works, and 1% is a good round number to use as an illustration of how it works.
Interest on Interest
In the simplest of worlds, $1,000 at 1% interest per year would yield, at the end of a year, $1,010. But that is simple interest, paid only on the principal. Money earns compound interest when the interest earned is added to the original deposit each time it is calculated. So in the case of a savings account, the interest is compounded, either daily (best) or monthly or quarterly, and you earn interest on the interest. The more frequently the interest is added to your balance, the faster your savings will grow. So with daily compounding, every day the amount that earns interest grows by another 1/365ths of 1%. At the end of the year, the deposit has grown to $1,010.05.
Okay, it’s a lousy nickel more. But at the end of 10 years, your $1,000 would grow to $1,105.17 with compound interest. Your 1% interest rate, compounded daily for 10 years, has added more than 10% to the value of your investment.
Yes, this is still depressing. But now consider what would happen if you were able to save $100 a month, and add it to that original deposit of $1,000. After one year, you would have earned $16.57 in interest, for a balance of $2,216.57. After 10 years, still adding just $100 a month, you would have earned $730.93, for a total of $13,730.93.
Still not a fortune, but it’s a reasonable rainy-day fund. And that is the main purpose of a savings account. When money managers talk about “liquid assets,” they mean any possession that can be turned into cash on demand. It is by definition safe from fluctuations in value. In real-people terms, it’s the emergency stash.
You can try any variation of the above for yourself on this compound interest calculator.
The Snowballing Effect
To truly understand the snowballing effect of compound interest, consider this classic test case, conducted by none other than Benjamin Franklin. The scientist, inventor, publisher and Founding Father was a bit of a showman, so it must have given him a chuckle to launch an experiment that wouldn’t bear results until 200 years after his death, in 1790.
In his will, Franklin left the equivalent of $4,400 each to the cities of Boston and Philadelphia. He stipulated that it was to be invested at 5% annual interest for 100 years. Then, three-quarters of it was to be spent on a worthy cause while the remainder was reinvested for another 100 years.
In 1990, Boston’s fund had about $5.5 million. Philadelphia had about $2.5 million. Due to the effects of compound interest, both cities managed to out-perform the rate of inflation over the 200 years. However, neither city came close to the combined $21 million that Franklin calculated they would achieve. The reason: interest rates fluctuated over time, rarely achieving the 5% annual rate that Franklin assumed.
Start Early, Save Often
Still, Franklin’s experiment demonstrated that compound interest can build wealth over time, even when interest rates are at rock bottom.
If you want to get started, you can find out which banks currently offer the best interest rates at BankRateMonitor or GoBankingRates. Make sure that interest on the account is compounded daily, and that no monthly fees are charged. (Note: Banks often state their interest rates as APY, or annual percentage yield, which reflects the effects of compounding. For more about this, see APR and APY: Why Your Bank Hopes You Can’t Tell The Difference.)
The Bottom Line
Unlike Ben Franklin, most of us have no desire to test what our money might be worth in 200 years. But we all need to have a little money set aside for an emergency. Compound interest, combined with regular contributions, can add up to a decent nest egg.