Compounding Interest – Why You Should Start Saving Now

My friend Lisa called me on tax day this year for savings advice and wanted answers regarding whether to open an IRA, how much to put in savings, and several other questions aimed at “let’s put together my financial portfolio on this phone call.”  I gave her my best shot with the caveat that financial decisions are more than a financial bottom line.  “Will you sleep well at night” is a question I posed frequently on the phone call and is a question I use to gauge my own decisions.

One piece of advice I did give Lisa is this:  Start saving now.  She retorted that she is not making very much money currently.  I suggested putting away at least a modest amount ($50 or $100) monthly to start.  Here’s why.

Money Down the Drain, Money at Rest, and Money at Work

Food, clothing, a roof over our heads.  We all have needs that we must provide for.  Day to day life, though, often causes our “wants” to creep into what seem like needs.  The morning latte, after work happy hour, and premium cable TV subscription go unquestioned and two hundred dollars are gone from the monthly paycheck.  This is money that goes to line somebody else’s pocket.  Sure, these expenses can bring us pleasure, but they are also dollars that are no longer in your wallet and can’t be used for important purchases (buying a house, car, engagement ring, etc.) or for major life events (college, retirement, etc.).  A timeline for these dollars and their value to you in the future can be summarized as follows:

Expense Amount 1 Year From Now 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$200 $0 $0 $0 $0 $0

An alternative is to pay yourself these $200 every month:

Amount Saved Monthly 1 Year From Now 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$200 $2,400 $12,000 $24,000 $48,000 $72,00

As you can see, a little discipline now can produce large rewards later.  What was a daily latte, a few drinks, or cable TV can turn into a significant charitable gift, a tuition payment, or a car.

Although these numbers are large, these same dollars can grow even larger.  Putting money to work for you via the power of time and compounding interest allows you to significantly increase your savings.  The following are examples of what a few amounts saved monthly can turn into when deposited in a savings account that yields .8% APY, a standard going rate as of 6/10/2012:

Amount Saved Monthly 1 Year From Now 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$50  $602.61  $3,601.81  $6,248.53  $13,017.30  $20,349.62
$100  $1,205.21  $6,123.62  $12,497.05  $26,034.59  $40,699.24
$200  $2,410.43  $12,247.23  $24,994.11  $52,069.18  $81,398.48

The Math Behind the Scenes

Note how putting away $200 a month for 30 years will allow you to save $72,000.  Introduce a relatively low interest rate like .8% and you accumulate $81,398.48 over 30 years, with $11,398.48 of that amount generated passively (i.e., without you lifting a finger).  Here’s how the $11,398.48 is generated.

A year after you decide to put away $200 a month into your savings account, you’ll have an extra $10.43 in your account, for a total of $2410.43.  So you made an extra $10.43- big deal, right?  At the end of year two, not only will you earn the .8% interest on $4,800 ($200 x 24 months) principal you saved, but you will also earn interest on the previous year’s interest.  At the end of year two, you will have a total of $4,840.21, with $40.21 of that being earned interest.  Should you continue to put away the $200 each month for 30 years, assuming a static interest rate of .8%, you will reach the $81,398.48 figure, with $11,398.48 in earned interest.

Note that my calculations are based on interest compounded monthly with additions made at the start of each compounding period.  Different banks will have different frequencies of compounding and different frequencies of posting, so keep this in mind when you start plugging away at online compounding interest calculators, as these variables will affect your overall savings.

Interest Rates and Time

Interest rates and time are key in passively growing your hard-earned cash.  The tables above also illustrate the power of time.  In a future post, I’ll explore other methods of saving that can allow you to grow your savings even faster over the same periods of time.

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