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Money
Earning Money
by Gary Foreman of The
Dollar Stretcher
Hello,
I just read your article on compound interest and have a
question. I have $25 a week that I can put away for a very long
time. Where can I go (bank, credit union, saving and loan, or
internet bank) to take advantage of compound interest?
Thank you,
Aaron
Aaron
is referring to an article I wrote a few years ago called
"Compound Interest for Poor People". In it, I
attempted to show how ordinary people could take advantage of
compound interest to save money.
Before
answering Aaron's question, we need to define what compound
interest is. And, unlike so many financial concepts, this one is
really pretty easy. It's simply earning interest today on the
interest you already earned yesterday.
For
instance, if you saved $1 and put it in the bank, you'd earn
interest on that dollar. If the interest rate were 5% paid
annually in one year they'd give you a nickel. If you left the
nickel in the account, it would also earn interest in the second
year. So next year you'd get more than a nickel in interest. And
that's when you're benefiting from compound interest.
A
certificate of deposit or other investment vehicle can create
compound interest by crediting your account with interest before
the maturity date. But Aaron can create compound interest
himself, by leaving his interest in the account. The only
difference is how frequently the earnings will be credited to
his account and begin earning additional interest.
All
of the institutions that Aaron mentioned will declare interest
periodically. It's common to find that interest is declared
either daily, monthly, quarterly or yearly.
Naturally,
it's better to have the interest paid more often. If you have
two CD's that both pay 5%, the one that's compounded daily will
earn more for you than the one that's compounded yearly. But,
you might argue, it's hard to compare choices with different
interest rates and compounding periods. And you'd be right.
Fortunately
you don't need to be a wizard with a calculator to know how much
you're really earning after the effects of compounding are
included. Just look at the yield.
For
instance, today's average rate for a one year CD is 6.36%. But
the yield is 6.55%. And that's what you're really earning. So
don't compare rates. Pick the highest yield.
Aaron
is in a great position to take advantage of compound interest.
If he can continue to put away $25 each week, he'll sock away
$13,000 in the next ten years. And if he gets a 5% yield on that
money it will grow into a nest egg of $16,897.
But,
that's being very cautious. Certainly CD's are safe. But, if
you're saving for the long haul like Aaron, you can get a higher
rate of return by buying stocks.
A
study quoted by John C. Bogle in his book Common
Sense on Mutual Funds showed that stocks earned an average
of 10.6% per year from 1926 to 1997. So even including the stock
market crash of 1929 the average return is better than CD's.
If
Aaron earned 10.6% on his $25 weekly savings he'd end up with an
account of $23,168 after 10 years. That's $6,000 more than the
CD would have earned.
OK,
perhaps you can't save $25 each week like Aaron. That doesn't
mean the compound interest won't work for you.
Suppose
you decided to skip your typical soda with lunch. You save $1.
Let's assume that you're 20 years old and you put the dollar
away at 5% and the interest is credited once each year. You also
leave the interest in the account to earn more interest. By the
time you're 65, that single dollar will be worth $9.43. That's
the magic of compound interest.
Still
not impressed? Suppose that you skip the soda every work day
this year. You'd save $250 on unpurchased sodas. Even if you
never added another cent after this year, when you're 65 you
would have an account worth $2,358.
Let's
take it a step further. If you got the 10.6% yield the single
dollar would become $102 when you reached age 65. Better still,
if you skipped a soda a day until age 65 that would grow to
$240,000. That's a lot of money for such a small lifestyle
change.
Please
notice the dramatic difference. It's caused by the effect of
compound interest being magnified by the higher yield. The point
is simple. If you can put the savings away for a number of years
you'll do much better by choosing a quality stock mutual fund
instead of a bank or credit union.
There's
also a sinister side to compound interest. If you borrow money
it's important to make payments at least as great as the
interest owed. Otherwise you're going to be charged interest on
the interest that you didn't pay.
OK,
let's summarize. Compound interest is a marvelous tool for
saving money. It works well for small or large amounts of money.
Compound interest magnifies any increase in investment return.
The effects of compound interest get larger as time goes by. You
can earn compound interest anywhere as long as you allow your
earnings to be reinvested.
Aaron
is off to a great start. And with the help of compound interest
he's likely to accumulate a nice nest egg over the years.
Gary
Foreman is a former Certified Financial Planner and founder of The
Dollar Stretcher website. You'll find hundreds of free
articles to save you time and money. Visit Today!
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