Five Things to Know About Compound Interest and Savings
Thinking about retirement can be very exciting for some people, but it would be safe to say that more people than not are actually pretty worried about how they are ever going to save up enough money to retire. Let’s face it, most people do not make a million dollars per year from the first year they enter their career field, which means they need to come up with an alternative way to save up the money they need for retirement. The good news, however, is that hardly anyone does make a million per year, and in fact, most people never even break the six-figures barrier. Considering how many people are enjoying a fairly nice retirement in comparison to the small percentage who made a whopping income every year of their career should provide investors with a great deal of reassurance that compound interest and savings can lead them down the right path. Before digging too deep into the retirement equation, however, there are five things that one should know or consider before beginning their investment program.
What is Compound Interest?
There are two types of interest, which are simple and compound. With simple interest, an investor would receive a flat-interest rate on the amount in their savings account. With compound interest, on the other hand, their principle, amount they have in their investment account, in addition to the interest rates will compound each year. For example, if someone has $1,000 in a compound-interest account, and they do not add a dime over two years, their $10,000 would now be worth $10,201 at a very-low 1% interest rate. Interest rates are currently a little low, but historically, they have always fluctuated. Regardless of what the rate is, however, most people would likely rather earn the extra $201 off their $10,000 than to be left with just $10,000 after two years. The bank will still use the person’s money to issue loans to other customers anyway, so people might as well take whatever savings account-related interest they can get.
Anyone Can Benefit
There seems to be a common misconception that only the super wealthy will ever make it anywhere by using compound interest; however, this could not be further from the truth. By using the equation in the previous paragraph of a $10,000 investment being worth $10,201 after two years while earning 1% interest and compare that to a $1 million investment, the million-dollar investment will earn about $20,000 in interest over two years. This is a huge difference, but the thing that most do not realize is that most people do not have a million in just a savings account anyway. The moral of the story is that everyone is going to make something, and the more they continue to invest, the better off they will be 30 or 40-years down the road.
How Fast Do Savings Compound?
Many people want to know how fast their savings account or other types of investments will compound. This is a tough question to answer in a straightforward manner because there are so many different variables. The simplest answer is that interest can either vary on a quarterly or an annual basis. However, the compounding time frames will vary from bank-to-bank and investor-to-investor. Theoretically, any compounding interest time frame will allow one’s savings to compound on a daily basis; however, the difference in a few points of interest could make the difference between earning a penny or less per day and earning a few dollars per day. A higher amount invested would also produce this same effect.
Like all good things in life, potential investors should also understand they have to make some sacrifices to get what they want. Many people buy things on a daily basis that they may feel like they need, but cutting back their usage could save them a ton of money over their lifetime. For instance, one fast-food meal per day, 365 days per year over a 30-year period equates to over $65,000. That $65,000 figure is just what someone would pay for a $6 drive-thru meal every day of the week, and this does not include what they would have earned in a savings account or other type of investment that pays interest. If people were to just cut that number in half and put the other half into a savings account at even just 1% each year, they would have nearly $40,000 in their savings after 30 years. Coffee and tobacco are the second-largest potential savings killers as many people spend $6 or more on a pack of cigarettes per day on top of their morning cup of coffee, which could cost upwards of $5 at some coffee shops. If one were to quit their smoking and coffee addiction and put every dime into an investment that yields 6%, they would have saved nearly $360,000 over 30 years.