What do you think of when I mention Compound Interest?
Are you one of those people whose eyes glaze over and start thinking about difficult mathematics lessons at school?
Even if you know what compound interest is and how it works, are you fully aware of its impact on your savings and investments in terms of hard cash?
This article is going to do the hard calculations for you and provide some real examples of why you need to strive for the best returns you can get from your savings because those percentages really do matter!
Let’s start at the beginning then…
What Is Interest?
Interest is the money that you get back from your savings and investments, also referred to as yield or return.
So if you save $100 for a year and get back $10 at the end of it, you have earned interest of $10, otherwise known as earning a yield of $10 or earning a return of $10.
What Is An Interest Rate?
The interest rate is simply the interest you have earned as a percentage of the figure you started with at the beginning of the period.
So, using the example above, if you save or invest $100 for a year and earn interest of $10 on the $100, you have achieved an annual or yearly interest rate of 10% (because $10/$100 = 0.1 i.e 10%).
Note that I am using annual interest rates here and will continue to do so in all the examples in this article but interest rates can be calculated over other time periods too, such as daily or monthly, for example.
What Is Compound Interest?
If we are only investing for one year, then in the example above, we will start the year with $100 and earn $10 interest to give us $110 at the end of the year.
Let’s say we leave that money where it is for a second year and let’s say that the interest rate in the second year is the same 10% again.
How much money will we earn in interest and how much money will we have at the end of the second year?
If you think you will earn the same $10 of interest, to leave you with $120 at the end of year 2, then you are incorrect!
That’s because, we are earning 10% interest on the new figure of $110 that we are starting year 2 with and 10% of $110 is $11, not $10.
So the correct answer is interest earned of $11 and a total sum at the end of year 2 of $121.
Another way of thinking about this, is to see that we are earning 10% on the original sum of $100 as we did before but we are also earning 10% interest on the $10 that we earned last year.
It is this 10% interest on $10 that accounts for the extra $1 of interest that we earn in year 2.
This extra interest is the added benefit of compound interest and it doesn’t suddenly stop at the end of year 2.
In year 3, 10% of $121 is $12.10, giving us a sum at the end of year 3 of $133.10, not the $130 that you might have expected.
This compounding goes on for as many years as we can leave the original sum and the interest earned alone without spending it and it can make a huge difference over periods of 10 years or more.
So if we left our original $100 and the interest earned every year alone and kept earning an annual interest rate of 10%, we would have $259 at the end of 10 years!
In other words, our original $100 would have more than doubled.
Bank Savings Rates
Unfortunately, in many parts of the world today, you will not be earning 10% interest on your savings.
Far from it, in fact.
As I’ve discussed in articles elsewhere, interest rates in many parts of the world are currently at historically low levels and are expected to stay low for several years to come.
Savings rates of 3% or less are typical now.
As a consequence, many of us are earning peanuts on our savings and will continue to do so.
For a savings interest rate of 3% and a starting sum of $100, that sum will have increased to a mere $134 after 10 years.
Beware Of Inflation
Note also that this 3% is before taking account of inflation, which will reduce your real spending power.
This means that despite having more money ($) in your possession, you won’t be able to buy as much with your money.
That’s because inflation is the measure of how much the prices of the things you buy, have risen (inflated).
So despite earning 3% interest, if the price of the things you’re buying have inflated by more than 3%,the combined effect is like losing money.
In this case, the inflation rate is said to be greater than your interest rate, because the prices of the things you are buying have risen (inflated) at a rate higher than your savings.
Whilst this might seem okay in the short-term, if this money is part of your life savings that you are building for your future or you are saving up for an event that is 10+ years away, then you can’t afford for this to continue for too long.
Unfortunately, with global economics as they are at the moment, Governments overspent and banks still de-leveraging after their recent excesses; interest rates don’t seem likely to be rising any time soon.
So if you want to get better returns from your savings and investments, you will need to start doing something different.
How To Earn 10% Average Return On Your Investments
If you’re sick of earning peanuts on your savings and watching your spending power dwindle every year, then you need to start investing instead of saving.
This is one of the things I will be talking about in my forthcoming teleclass:
Three Secrets To Tripling Your Investment Returns
If you’d like to know more about the teleclass, what you might learn and when it will be, then click here.
You can sign up for the 60-minute teleclass there too.