Money Earning Money Little By Little

by Gary Foreman

Money Earning Money Little By Little photo

The best way to build savings is to let your money earn you more money. Find out how your money can go to work for you little by little.

Gary,
I 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, savings and loan, or online 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.

What is compound interest?

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.

Why the yield is important

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 CDs that both pay 2%, 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.

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How to get a higher rate of return

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 $13,326. But, that’s being very cautious. Certainly CDs are safe. But, if you’re saving for the long haul like Aaron, you can get a higher rate of return by buying stocks.

According to the NerdWallet.com, “The average stock market return is about 10% per year for nearly the last century.” So even including the stock market crash of 1929 the average return is better than CDs. If Aaron earned 7% on his $25 weekly savings, he’d end up with an account of $17,479 after 10 years. That’s about $4,000 more than the CD would have earned.

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 $2,246. Let’s take it a step further. If you got the 7% 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 almost $77,000. 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.

A caution about compound interest

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.

You don’t need a lot of money to take advantage of compound interest

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.

Reviewed November 2021

About the Author

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. You can read Gary's full bio here. Gary shares his philosophy of money here. Gary is available for audio, video or print interviews.

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