In case last week’s blog didn’t convince you of the benefits of saving, this week we’re going to talk about compound interest. Compound interest is often referred to as interest on interest because it is “calculated on the sum loaned plus any interest that has accrued in previous periods” (check out the Oxford Dictionary of Business and Management, available online through Andersen Library, for more definitions like this). This is in contrast to simple interest, which only accrues interest on the principal amount.
Stick with me. A fair amount of financial jargon was just used, but understanding compound interest is critical if you want to save money and pay off debt efficiently. Compound interest is a two-edged sword. It’s a fantastic help when saving money and it’s a tremendous burden when you owe money. Here’s how compound interest works:
You have 100 bunnies; this is your “principal.” Each month you get 10 more bunnies, just for kicks. If the bunnies never reproduced, at the end of one year you would have 220 bunnies. However, your bunnies reproduce (compound) at a rate of 0.5% each month, or 6% per year. At the end of one year, you’ll have about 229 bunnies. That’s 9 more bunnies than you would have had without any reproduction (ahem, compounding)! The longer you do this, the more bunnies you’ll have. Before you know it, you’ll have about a zillion bunnies.
(A lot of math goes into finding that 229 number, and I don’t want to scare you off. You can use this calculator to get the result I got above. Make sure you use an interest rate of 6% (0.5% x 12 months) and put 12 into the times per year box.)
Now let’s translate compound interest into dollar terms. You put $100 into a savings account and add $10 each month. The interest rate on your savings account is 6%, and the interest compounds monthly (or at a rate of 0.5% each month). If you don’t take money out and you continue to add $10 a month, in 30 years you’ll have about $10,647. Compare this to the $3,700 you would have if all you did was add $10 a month without the benefit of compound interest.
Keep in mind that compound interest is also used in debt situations and the interest rates are usually higher. This means your debt will accumulate much faster than your savings. To learn more, check out this video from the Federal Reserve Bank of St. Louis’ No Frill’s Money Skills series.