Time Is Money: Compounding cents into dollars
We all have dreams of retiring with tons of savings and living on a private island, taking a European vacation, and living the life. These things (maybe not the private island) are possible with some planning and a little luck, because we have a huge advantage -- we have time on our side. With some good saving and investing habits, and the gift of time, your money can grow to make your dreams come true.
With the gift of time, you can set monetary goals. If you want to have $1,000 for a great vacation in two years, divide $1,000 by 24 months. Set aside about $42 a month and bon voyage! Planning ahead helps make your goals more attainable -- saving $42 a month is more reasonable than trying to come up with $1,000 tomorrow.
This equation, however, doesn't account for the compounding of interest over time. Compounding is interest earning interest. For example, let's say that you put $100 in a savings account that earns three percent APY (annual percentage yield) compounded annually. After the first year, that three percent is assessed and added to the balance of your account, which is now $103. The next year, the three percent interest is assessed on $103, and $3.09 is added to your account. See the pattern?
The compound interest chart below shows what interest compounding yearly will do over time. The blue line illustrates what happens when the initial investment is $1,000, and the APY is 3.7 percent with no additional contributions. The pink line shows what happens under the same conditions, but with an additional $500 added annually.
Regular savings accounts typically earn very low interest (sometimes it doesn't even keep up with inflation). You can spice things up by getting a share certificate or a certificate of deposit (CD), a money market account (MMA), or a high-yield account.
- Share certificates/CDs often have terms ranging from three months to five years. They earn higher interest than regular savings accounts. If you remove funds before the end of the term, you usually forfeit part or all of the interest for that term. Also, they often have minimum balance requirements.
- MMAs usually require higher starting balances than regular savings accounts, but tend to earn more because transactions are limited.
- High-yield accounts usually have higher rates than regular savings accounts, and you can typically move money in and out at any time.
An easy way to start saving is to use direct deposit to send part of your paycheck to your chosen savings account, and let the gift of time work its magic. Before you know it, you will have saved a good chunk of change, moving one step closer toward your goal.
Doubling your money is a common investment goal, but knowing how much time it will take can seem difficult. With the Rule of 72, it's as easy as simple division. The rule states that if you divide 72 by the annual rate of return you're earning, you'll get the number of years needed for your money to double. For example, if you are earning 9 percent, 72 divided by 9 equals 8 years. This rule doesn't always work perfectly, but it comes pretty darn close to the actual calculations.
Ignoring the little voice nagging you to buy something can be a struggle. It's important to set aside some money for fun, but stick to your savings plan. Every time you want to spend from your savings, think about the money you could earn by leaving it there. At five percent compounded annually, the $100 you would have spent will be $105 in a year. That may not sound like a lot, but compound enough and those five percentage points can add up to some serious cash! It's all about using your time.
Sources: dinkytown.com; fool.com; bankrate.com; investopedia.com; bea.gov; bls.gov