It’s never too early to think about the long term, and having goals that can put you ahead of the game when others are struggling just to stay even. Your most valuable asset is time, and you will never have more of it than you do right now. By taking advantage of time and the magic of compounding, you can easily accumulate the money for a down payment on a house without breaking a sweat. If you were to save just $50 a week starting at age 18, you would have more than $50,000 by the time you are 38 (assuming 1.75% interest).
How Interest Bearing Savings Accounts Work
The bank takes a big portion of your deposit and loans it out to other people or businesses. It pays you interest for the use of your money, while it earns interest on the money it loans. Sounds like a scheme, but it is perfectly legitimate as long as the bank keeps enough reserves to pay you when you demand a return of your deposit. That’s why they call it a demand deposit.
The Magic of Compounding Interest
For most types of savings accounts, the bank credits interest once a month. So, with each month, your account earns interest on your principle (your deposit) and on the interest accumulating in the account. The effect is called compound interest, which when you extrapolate over time becomes quite magical.
Given the choice to receive $10,000 each day for a month, or a single penny that doubled in value each day for a month, which would you choose? If you chose the former, you may feel kind of silly when you find out that your $10,000 daily gift amounts to $300 payday loans Northfield, NJ online,000 while the doubling single penny would have produced around $5 million. Such is the magic of compounding.
Compounding interest stems from the fact that your money not only earns interest on the principle; it also earns interest on the interest that is earned. A thousand dollars earning 5 percent a year (compounded annually) will grow to $1,050 at the end of the first year. In the second year, it earns interest on both the original $1,000 and the $50 of interest, for a total amount of $1,. That is the compounding effect of interest earning interest. At this rate your account will double to $2,000 in about 14 years. (If you want to know how many years it will take for your money to double, divide the number “72” by the interest rate).
Time Provides the Magic
Of course, there can be no magic without time. The “time value of money” is the absolute key to the magic of compounding interest. When the compounding effect of interest earned is combined with time, the growth of your money becomes exponential, as in the case of the penny. Consider the following example of two people who invest the same amount of money for retirement at different periods of time in their lives:
- Starting at age 25, David contributes $20,000 a year to his retirement plan. Then, at age 45, he stops saving altogether.
- Wendy waits until age 45 before contributing $20,000 to her retirement plan and continues to save until age 65.
- If we assume they each earn 6 percent per year on their retirement savings, at age 65, David will have accumulated more than $2,500,000 while Wendy would have just less than $800,000. Yet, they both saved the exact same amount of money.
