Understanding The Magic of Compounding Interest
By Bill Addiss
Certainly, earning interest on your money is rewarding. Even more rewarding is earning interest on your interest and having that return compound over time. As indicated in Einsten’s quote above, he viewed COMPOUNDING interest as the eighth wonder of the world. Let’s take a look at why.
The chart below illustrates how impressive the exponential increase in the value of money as it compounds is. You can see how $100,000, compounded at a 5% annual rate, would grow to over $265,330 in 20 years. For long term investing, like IRA or 401k accounts, supplemental retirement planning or meeting any long term goals, the magic of compounding is a critical element to successful, long term investing.
Did you know that idle money (money not earning interest) actually COSTS you money? This is just one of the numerous pitfalls to money left idle, like that in most checking accounts.
Pitfall number one is obvious from the chart above; you do not get to enjoy increase in growth that compounding interest provides. Just as significant, however, is that inflation makes the value or purchasing power of your money deteriorate over time. That means that the purchasing power of your money (how much you can buy with it), actually deteriorates over time.
As the chart below illustrates, assuming only a 2% inflation rate, $100,000 deposited in a non-interest bearing account would deteriorate in purchasing power to be equal to only $67,200 after 20 years. Stated another way, that $100,000 would buy you 32% less in 20 years than it did when you deposited it!
How To Get Your Money Working For You
As the charts illustrate, earning interest on your money is fundamentally critical, and having that interest compound is just as critical. Here are a few tips for how to enjoy the benefits of compounding interest.
Sweep your cash into a money market fund. Traditionally, most checking accounts offered by banks pay 0% interest. This means that the bank is taking your deposit, paying you 0% to essentially borrow that money from you and then lending it out to borrowers and charging them a rate of interest. This model is great for the banks!
There is an alternative, however. Many banks offer their depositors the option of investing in a money market fund or other interest bearing account. It is important to realize that money market funds are NOT FDIC insured, but they do offer investors a rate of return not found in a checking account. They also offer you liquidity like a checking account; you are not locked into a long term investment and can access your money the same day you request it. Additionally, many money market funds even offer their investors a checking option, where they can write checks against the balance in their money market fund.
Most brokerage firms also offer their clients the opportunity to sweep their idle funds into just such a money market account. After a decade of historically low yields, short term interest rates have been on the rise for the past 2 years. Many money market funds now offer yields approaching 2%, and given what our Federal Reserve has indicated they are going to continue to raise interest rates, most experts expect these yields to rise higher this year.
Utilize Dividend Reinvestment (DRIP) Plans for your stock dividends. Today, many companies and many brokers offer investors the opportunity to reinvest stock dividends into more stock of the company. So, rather than receive your dividends in cash, reinvest those dividends to buy additional (or even partial) shares of the company’s stock. Reinvesting the dividend distribution into more paying stock grows your account and amounts to a compounding of the dividend and more long term growth.
Check with your broker and banker about other interest earning options they offer. For example, CDs are an option if you don’t need to keep large amounts of money idle in a non-interest bearing account. Traditionally banks offer Certificates of Deposit (CDs) with maturities as short as one month, which pay interest rather than keeping your money idle. Granted, these are not as liquid as checking or passbook savings accounts, but they do give you the chance to gain, not lose purchasing power and interest, if you can afford to tie up the money for a short period of time.
About the Author
Mr. Addiss develops and facilitates educational programs for a variety of major financial institutions, government agencies and foreign governments.