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Compound Interest

The Effects of Compound Interest

The magic or secret in saving is the power of compound interest. When you're saving, the financial institution, retirement plan, etc., adds interest to your savings at regular intervals, generally every month. If you don't touch the interest, but let it add to your lump sum, then you start to earn interest on your interest, as well as on the original amount you saved. This is called compound interest.

The longer you leave your money, the more powerful the compound interest effect. So the earlier you start saving, the more you make from compound interest. The same applies to other investments such as the mutual fund unit shares (available in most retirement plans), where the dividends and growth of the unit share value is automatically reinvested in your retirement account.

The Rule of 72

What does it take to save a large some of money?  There's an easy rule you can use to work out how your savings or investments can grow with compound interest.

Just divide the average annual return into 72. The result tells you how long it will take for your money to double without further savings.

For example, you have $10,000, which is earning 8% interest (401k pre-tax). 72 divided by 8 = 9.

Every 9 years your $10,000 will double, therefore:
 

After 9 years you have: $20,000
After 18 years you have: $40,000
After 27 years you have: $80,000
After 36 years you have: $160,000


That's why it is so important to protect your 'nest egg'. If you allow your money to grow you can double your savings every 9 or 10 years.  Someone who is 25 years old has 40 years to allow the magic of compound interest to work. When you change jobs resist the temptation to 'cash-out',  Take advantage of the 'roll-over' option.  Otherwise you'll be starting all over again from zero, and you can never make up for those earlier years of saving.

When investing in your 401k retirement plan use the rule of 72 to remind yourself of the power of compound interest.

 

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Information is provided for review and consideration only. Please consult legal and tax advisors for practical advice pertaining to your business and personal situations.

This page was last reviewed and/or updated on Sunday, February 28, 2010 10:56 PM

 
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