Compound Interest

Compound Interest

What is Compound Interest?
 
Albert Einstein, well known for being smarter than the average, once called compound interest "the greatest mathematical discovery of all time". However it’s not totally necessary to be as intelligent as Einstein (or even half as smart for that matter) to understand compound interest.
 
When you save money in a bank savings account or a CD, you earn interest on that money. The next year, you earn interest on both the original capital and the interest earned from the previous year. In the third year, you earn interest on capital and interest on interest earned in year one and year two. It goes on and on with no limits. And that, in a nutshell, is the seventh wonder of the world – compound interest!
 
The effect is most often described similarly to that of a snowball. If you stand atop a mountain and gather some snow into a ball, then roll it down the mountain, it gathers snow as it goes creating a bigger and bigger snowball. If your hill is steep enough you could end up with a very large snowball at the bottom!
 
While compound interest itself is a basic concept, there are several ways to maximize the amount of money you could be due. Here are five key points to keep in mind:
 
1. Start as soon as you can: The earlier you start investing, the more time you have for the effects of compound interest to accrue. A person who invests $200 a month from age 25 to 35 and then lets their investments grow is likely to have more money at age 60 than a similar person who invests $200 a month from age 35 to 59.
 
2. Small differences in return are crucial: While 1% might not seen like a lot, the difference between 6% or 7% over long time periods is gigantic.
 
3. Don’t disrupt the cycle: It’s important only to invest money and let it grow when you have no pressing need for it. While there is nothing wrong with keeping money in a bank account, the more time your money has to grow the more it will.
 
4. Don’t laugh off the small stuff: Contributing just $100 a month for 40 years at 12% will see you end up with close to $1,000,000 in savings.   And that’s just $100 a month.
 
5. Give it time: You must be patient. There is no such thing as a quick buck. Compunding takes time but the benefits are way in excess of the time costs.
 
A Practical Example

$20 000 invested at a compound rate of 15% for 30 years provides some astonishing results:

YEAR                                                                      AMOUNT
1                                                                                $23,000
2                                                                                $26,450
3                                                                                $30,418
4                                                                                $34,980
5                                                                                $40,227
6                                                                                $46,261
7                                                                                $53,200
8                                                                                $61,180
9                                                                                $70,358
10                                                                              $80,911
11                                                                              $93,048
12                                                                            $107,005
13                                                                            $123,056
14                                                                            $141,514
15                                                                            $162,741
16                                                                            $187,152
17                                                                            $215,225
18                                                                            $247,509
19                                                                            $284,635
20                                                                            $327,331
21                                                                            $376,430
22                                                                            $432,895
23                                                                            $497,829
24                                                                            $572,504
25                                                                            $658,379
26                                                                            $757,136
27                                                                            $870,706
28                                                                         $1,001,312
29                                                                         $1,151,509
30                                                                         $1,324,235

An investment of $20,000 turns into $1,324,235 after thirty years, without a single cent added.


Savings Rates Hit New Lows, CD Rates Flat - Weekly Review

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Savings and CD rates continue to hover at pitiful rates. Average savings rates reached a new record low of 1.51% APY last week, down 3 basis point from 1.54% APY the previous week. Average one-year cd rates actually rose 3 basis points 1.95% APY. Average three-year and five-year CD rates remained steady at 2.67% APY and 3.18% APY respectively.

Last week was nother relatively quiet week in the markets. News was dominated by the devestating earthquake in Haiti as well as the battle over healthcare and the election in Massachusetts. I live in Massachusetts and never in my life have I seen so much campaigning. Usually Massachusetts receives little to no attention in national elections since the race is usually a foregone conclusion. Now, every twenty mintes the phone is ringing with an ad for one candidate or the other and almost every commercial is an election ad.

The stakes are large no matter who wins. Health care eats up 16% of the Federal budget and that number is expected to rise as the cost of healthcare continues to grow at 7-10x the rate of inflation. A friend of mine works in the benefits department of a major corporation and he told me that no matter what happens, the quality of healthcare is going down, or the price is going up. Companies can no longer afford to subsidize as much of the cost. Many of you have already seen it in high-deductible plans or plans with very expensive premiums. Expect this trend to continue.

Now, onto the rates.

CD and Savings Rates

Savings and CD rates continue to hover at pitiful rates. Average savings rates reached a new record low of 1.51% APY last week, down 3 basis point from 1.54% APY the previous week. Average one-year cd rates actually rose 3 basis points 1.95% APY. Average three-year and five-year CD rates remained steady at 2.67% APY and 3.18% APY respectively.

Savings,CDRateAnalysis

Like the Treasury yield, BestCashCow has developed its own yield ratio for deposit accounts - the spread between savings rates and 36-month CDs. In some ways, this ratio is purer because it cannot be influenced by government debt, Fed Treasury purchase programs, and other attempts to manipulate rates. As you can see below, the ratio between savings accounts (a short duration deposit account) and 3 year CDs has 1.15. Savings and money market rates have dropped while 3 year cds have essentially stayed flat. The ration remains very elevated, mimicking the Treasury curve. We'll be watching how the ratio develops over the next month to see if it provides any additional clues to the state of the market in 2010.

SavingsandCDSpreadAnalysis

At this point it's still hard to recommend putting money into anything longer-term than a 12-month CD, especially with rising equity markets and signs that the economy may be coming back to life. Many depositors may be willing to lock money away for 5-years at close to 3%. To me that's just not enough of a return for that period of time. For those worried about interest rate risk, cd laddering may be a good way to smooth out the return you receive from your CD portfolio.


ING Direct Survey - 64 Percent of Americans Will Stash More Cash in 2010 Than 2009

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A survey commissioned by ING Direct has some interesting findings on American attitudes towards savings and debt.

A survey commissioned by ING Direct has some findings on American attitudes towards savings and debt. Amongst the findings:

  • Two-thirds, (64 percent) of Americans plan to stash more cash in 2010 than in 2009;

  • More than nine out of ten (93 percent) Americans with children under 18 in the household say earning enough to cover monthly bills is important as a financial goal for the New Year;

  • Close to nine out of ten (89 percent) say building an emergency fund is important;

  • More than two thirds, (71 percent) of Americans say investing more for retirement is important, while 60 percent say paying off credit card debt is an important financial goal for 2010; and

  • Spending less overall is an important financial goal for 91 percent of Americans.

None of this strikes me as surprising.

In addition, the survey found that nearly four in ten (37 percent) Americans are hopeful about America's recovery in 2010, while about one in five (19 percent) are feeling pessimistic or anxious and stressed about the economy. Somewhere in-between these two extremes are a lot of people who don't know which way the economy will go.

The press release quotes the President of ING Direct. He says:

"Americans believe 2010 will bring some economic recovery," said Arkadi Kuhlmann, President of ING DIRECT USA. "However, before Americans can say goodbye to the recession, they must first get their home economics in order. Having a savings account with emergency funds, managing expenses to avoid late fees and interest payments, and eliminating debt should be top priorities this year."

I don't see how the results support that statement. After all, only 37% of Americans were hopeful about America's recovery. But hey, it helps to be optimistic, right?