July 31st, 2012
Compounding interest is when you place funds in any investment (often a CD) and you leave the interest in the account which then earns interest itself and your final earnings will be much greater. This can also be accomplished in securities accounts by electing to re-invest dividends.
Let’s look at a couple of examples.
Example 1: Let’s say you invest $100 into a 10-year CD at 3.00% APY with daily compounding. After 10-years, this will have grown to $134.39. Now, I realize, that doesn’t seem like much, but let’s keep going and see where we get. After 25-years, you will end-up doubling your funds.
Example 2: Let’s start with the same $100, but you also commit to adding $25 a month (which doesn’t seem like a whole bunch). Now after 25-years, you’ll have $11,289.52. That is pretty impressive. If you start something like that for a child or grandchild when they are 5-years old, when they reach 30, you’ll be able to present them with a sizable gift.
You will notice that I picked a pretty low interest rate. I did that on purpose. Even in a low rate environment, you can turn small amounts into a decent return. It just takes discipline. If you are able to get 3.50%, you will end up with almost $1,000 more, $12,203.77.
Example 3: Now that you are excited, you want to try to make a little bigger difference. How about an initial $1,000 investment with $50 added monthly. After 25-years, you’ll have $24,252.17
And for our final example, you take the $24,252.17 and maybe take a little risk. Give yourself another 25-years and still contribute just $50 a month. Let’s assume a 5% interest rate (well below historical averages for safety sakes). Your final total: $114,204.33. Now that is pretty darn impressive.
We have actually done something similar with our kids. Whenever they earned money, they had to put at least 10% into the bank. In addition, birthday and Christmas money from one of the grandparents also went into savings. Now, even with ridiculously low interest rates, they are able to stow away a decent amount for their first car. Obviously, the ones with more discipline are able to put away more.
I used the calculator linked from here for my calculations (http://www.hcuonline.com/HCU_Calc_PeriodicSavings.html). Interestingly, they seem to have decent savings rates for IRAs. Although, I suspect their field of membership is quite limited, shows you that the above is seemingly quite possible.
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Have an awesome day.
-- By +Chris Duncan