Making Your Money Work Harder Using Compound Interest

We understand the theory behind saving money for our retirement, but how many of us actually do it? In fact how many of us even bother putting any money aside for a rainy day?

Many of us have the same reasons for not saving money. “There isn’t enough left at the end of the month”, or “a small amount of savings won’t make any difference”. Yet the power of compounding actually makes saving money not only worthwhile, but also amazingly exciting.

If you haven’t yet discovered the magic of compounding then sit tight and prepare to be dazzled!

The Magical Power Of Compound Interest

When asked, many young people think saving is “boring”, or that “interest rates don’t make much of a difference”, yet this couldn’t be further from the truth. In fact the power of compounding can turn a very small amount of money, into a mammoth figure over a period of time, and that is really the key.

So what exactly is compounding and how does it work?

The actual word compound means to grow on top of oneself. Interest is the key to compounding and is what makes it an opportunity not to be missed. Let’s look at how compounding works. When you put money into a savings account you earn interest on the amount you save. For example, if you put $1000 into a savings account with an interest rate of 5% p.a then at the end of the year you’d have $1050.

It doesn’t seem a big difference but look what happens the year after. This time at the same rate of 5% interest you now have $1102.52. What happened?

Well in the first year you earned 5% interest on $1000 but in the second year you earned 5% but on $1050. Instead of the $50 in interest I earn in year 1, I make $52.50 in year 2 as the interest was paid on a bigger amount.

If that $1000 was saved at a 5% interest rate for 30 years and was never added to it would be worth $4321.94!

Now that may not be enough to retire on but can you imagine what would happen if you had saved $1000 each year? The interest would keep being added to a larger figure and would eventually grow explosively.

Like Watching Grass Grow

It’s often been said that watching savings grow through compounding is much like watching the grass grow. It is a process that takes some time but becomes very worthwhile at the end of the road.

If you were to look at a 30 year compound savings plan on a graph then for the first few years the line would be very flat and steady. You would barely be able to see an upward trend, but as the years go by you’d notice the line would suddenly become much steeper before jumping almost vertically.

It was in fact Einstein himself that said, “If man could only grasp the power of compounding he would have mastered the most powerful force in the universe!”.

So how can we use compounding to make our money work harder for us?

Work It Baby!

Start today! – Many of us get into the habit of thinking it’s OK to put off starting to save until later in life. The reality however is that the later you start the less you’ll have at the end of it all.

As an example, if you wanted to retire at the age of 65 years old with a nest egg of $1,932,528.09, if you started at 18 years old and got an interest rate of 8% you’d need to save $4267.01 each year to reach your target, however if you waited until you were 30 years old to start saving you’d need to put away $11,214.97 a year to make your goal figure.

The earlier you start saving the quicker the power of compounding takes hold.

Get the highest interest rate possible- It seems obvious but the higher your interest rate the more money you’ll earn long term. Keep your eyes out and regularly check to see if you’re getting the best interest rate possible.

If someone’s offering you a better deal don’t be afraid to move your money.  Make sure you won’t be penalized by your current savings provider for doing this, and if not then don’t feel guilty about shifting the lot.

Keep adding to the total- We’ve already seen an example of what can happen when money is saved and left to compound over a long period of time. But what happens when you keep adding to your savings is nothing short of miraculous.

The more you save the more cash your interest is being compounded on. Think about it this way, 10% of $100,000 is much more than 10% of $1000 and the more you put away the larger that figure will become.

The Rule of 72

An easy way to work out how the power of compound interest will see a figure double is by using the rule of 72.

You take your interest rate and divide it by 72.  Using our 5% example, you’d take that 5% and divide it by 72 giving you 14.4. That tells you that $1000 will double to $2000 in roughly 14.4 years if you never touch it or add to it.

At a rate of 6% it would take 12 years because 72 divided by 6 is 12.

Although the thought of saving money may not be sexy or inspiring at first, when you consider what the power of compounding can do to your long term outlook the idea becomes a lot more appealing.

The earlier you start the better, and the more you put away the faster compounding will take hold. Someone once said the only way to get rich was to spend less than you earn and to reinvest the difference. Adopt that outlook, combine it with the power of compounding, and your nest egg could end up truly golden.

This article was written by Timothy Ng. You can read more of his work at CreditCardFinder.com.au where he has a number of comprehensive guides to all types of credit cards.

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Comments

  1. says

    It is amazing how much an investment can build up through compounding. Young people really need to be taught this in school or by their parents. Then they can start saving earlier and make saving or retirement that much easier.

  2. says

    Good stuff, especially the rule of 72. Compound interest is boring, that is why folks look for something more exciting with higher returns and end up getting their fingers burnt. Leaving your money well alone to compound can be hard when you have itchy spending fingers

  3. says

    Thanks for laying it all out there. It’s so important to know the POWER of compound interest. That in itself would be enough to start saving as a teenager.

  4. says

    Definately not an easy subject to explain clearly, but you accomplished it grandly! The 72 rule certainly sweetens the maths.

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