Your Money Wants to Give You More Money: A Look at Compound Interest

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Last week we explored the numbers behind credit card debt. This week we’re going to take a look at how compound interest works in your favor by giving you more money for free.

With the ups and downs of the economy over the last twelve months, it’s difficult for anyone to know what to do with your money. Invest in the market and ride the roller coaster, or keep it at home where you can see it and no company will steal it?

The historical returns of the market, mixed with inflation, shows that keeping your money under your pillow isn’t worth it and sometimes you need to take some risk. Inflation has averaged around 3% a year so your money is losing value everyday it sits in your wallet or in a safe at your house.

The power of compounding interest is something that cannot be ignored. At first, it sounds like another boring financial term like dividend or exchange-traded fund, but compounding interesting is your best friend, and when you see it in action it really changes your mind about keeping your money in a safe at home. Picture your money giving you free baby money as a thanks for putting it in a savings vehicle.

Here are two graphs that compare investing and utilizing compound interest, versus keeping money at home.

Andy and Kevin are both 25 years old. Andy invests $1 per day for 40 years, while Kevin keeps $1 a day under his mattress.

Check out the massive difference in sums after 40 years:

Kevin
25 Years Old
Puts $1 Per Day Under His Mattress
Average Return: 0%
Invested $14,600
Return After 40 Years $14,600

Andy
25 Years Old
Invests $1 Per Day
Average Return: 8%
Invested $14,600
Return After 40 Years $105,956

The difference after 40 years is a total of $91,356!

I’ll admit, it feels discomforting when someone else has control over your money. It feels safer when you can see your money in your house. You know that some greedy CEO in New York City can’t take your money and leave your family with nothing.

However, the numbers above are not even adjusted for inflation. The value of your money loses 3% per year, so an investment in the stock market is a fight against inflation, if nothing more.

With inflation at 3%, Kevin’s $14,600 will actually be equal to $4,317 in 2049. By keeping your money under your pillow for 40 years, it becomes a third as valuable and will force you to make even more money in 40 years to keep up with your lifestyle.

The key is to use your money in your favor. It can’t do anything while sitting in a 0% interest checking account. Even a more conservative investment like a 3% CD at your local bank will bring about a much better return.

If Kevin had put his money into a CD over 40 years it would have returned $28,238. A difference of $13,638 – almost double the amount if he were to leave it under his mattress. Plug your own compound interest numbers in over at Money Chimp and see what your money could be doing for you.

These numbers are meant to get you paying attention your money as early as possible. The earlier you recognize how powerful compound interest can be, the quicker you can make a change and get your money working for you.

Make Money With Your Money

-Open an Online Savings Account. If you have any excessive amount of extra cash sitting in a checking account, move it to an online savings account at ING or another online bank. These banks pay a much higher interest rate and moving your money there is a major step in the right direction.

-Check out Certificate of Deposts (CDs) at online banks or your local bank. These tie up your money for a certain amount of time, but they usually have higher interest rates than savings accounts. As a bonus, CDs are a very safe way to keep your money.

-Start a Roth IRA and invest in low-cost index funds. These funds invest in the market average and aren’t effected as much by a CEO stealing money or a company’s poor third quarter profits. You can research these more at sites like VanguardSchwab, or Fidelity.

We could sit here and debate the best way to optimize your money, but the examples above are meant to be a nudge. A nudge to get you paying attention to your money and its earning’s potential.

What I learned from every paper in college is that the most difficult part of any project is getting started. The hardest work is done at the beginning and online savings accounts, CDs, and index funds are all low-maintence investment vehicles once they are set up. I talk more about the importance of getting your finances going in the right direction in the post, Get the Money Snowball Rolling.

Compounding interest involves giving up a little bit of control for your financial future. Let your money breath and it will come back even stronger in future years.

What about you? Why and when did you wise up to the magic of compounding interest?

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Photo by AComment


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