"Please don't tell me that if I had $1,000 and invested it for 10 years at 10% interest I'd have a big pile of money. I don't have $1,000 and paying next month's bills is my biggest problem." We've all seen articles on the wonders of compound interest. But most of us don't have large sums of money just lying around waiting to be invested wisely. So we're going to see how us 'poor folks' can apply compound interest to make a difference in our lives.
First, we do need to make sure everyone understands compound interest. Stated simply, it's when you earn interest today on the interest that you earned yesterday. Suppose you banked $1.00 yesterday and earned one cent interest. Today you'll be earning interest on $1.01. The interest that you earn on that one cent is called compound interest.
Unlike some financial deals, you don't need to be a wizard to use compound interest. There are a few simple rules that apply in all cases. If you apply them you'll improve your financial lot.
It's always better to compound more frequently. Daily compounding is better than monthly or quarterly. You'll begin earning interest on interest on the second day, not the second month. So you want to always choose the shortest compounding period offered to you.
More time magnifies the effects of compounding. Let's say you put some money away today at 10% interest. That money will double in about 7 years. If you left the interest in the account you'd have twice as much money earning interest in years eight through fourteen. It's like you were getting 20% interest on your original savings. By year 15 you'll be earning 40% interest on your original savings! The rest of the account will earn a less depending upon how long it's been in the account.
Time and compound interest, however, are a double edged sword. That 14% interest you're paying on your credit card debt is actually much higher if you figure in compound interest.
OK, now let's get down to how us poor folks can take advantage of compound interest. Could you find a way to save $5 per month? Maybe skip two lunches at McDonalds or rent two fewer videos each month. If you drive a lot you might save 4 gallons of gas by getting rid of the extra weight in the trunk of your car. Maybe send a couple of handwritten notes instead of greeting cards. If you look (and you really want to) you'll probably find some way to save that $5 each month.
"But, at that rate it'll take forever to save anything." Well, let's see. If we save $5 per month, earn 10% interest compounded monthly and continue to do that for 10 years what'll we save? Well, we'll have saved $600 (120 x 5). But the account will be worth $1,037. That's enough for a pretty nice television set or a fairly major repair job on your home or auto.
"You don't understand. I have credit card debts. I can't save money." Oh, but you're wrong my plastic using friend! Let's suppose you take that $5 per month and add it to your credit card payment. You'll actually do better than the saver. Let's assume that your credit card interest rate is 14% annually. After ten years you'll have paid off an additional $1,315 in credit card balance.
Maybe you could do a little better. How about saving $5 per week? That's about $21.50 each month. You might be able to save that much by adjusting your thermostat by one degree. Take a brown bag lunch to work two days a week. One less dinner out each month. Drop a premium cable channel or two. Maybe a combination of smaller savings.
What would that do for you? Well, if you just put $5 a week away at 10% interest you'd have saved $2,600 over 10 years. But your account would be worth $4,452. Now that's a fair amount of money. A nice down payment for a car. Or you could remodel a bathroom. Or maybe you just want to spend the interest that will be earned on the $4,452 each year. You could spend about $440 every year forever and never touch your principal. Wouldn't it be nice to know you'll always have money for Christmas presents? Or to have a good start on your vacation each year?
But, maybe you're deeper in debt and just can't see your way out. You owe thousands of dollars on your credit cards. Short of Aunt Harriet leaving you an inheritance, those cards will never be paid off. Well, you could apply your $5 per week to those cards. At 14% interest you'd wipe out $5,633 in credit card debt in 10 years!
So now you have a choice to make. You can say that all that fancy compound interest stuff is just for the wealthy. Or you can recognize that the same principles work for smaller amounts. And begin to think and act on that knowledge. Would you give up two Big Burger meals each month to have $1,000 in ten years? Now that you know the facts, it's up to you.
Gary Foreman is a former certified financial planner and is currently the editor of The Dollar Stretcher where you can find hundreds of articles to help you save money.
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