There really is a reason to start saving
early, September 8, 2006, 2D.
People
interested in getting good deals on home and automobile
loans may have just missed the boat. Recent increases in
interest rates have made it more expensive to borrow money.
Higher
interest rates are not bad for everyone. For those wishing
to save money, the interest rate hikes have been
beneficial. It is now common to see 12-month certificate of
deposit (CD) rates at or above five percent. This article
is intended to be an introduction to savings and compound
interest for those who might be unfamiliar with these
concepts.
Financial consultants advise people to begin saving money
for retirement as early in their lives as possible. Most
consultants will tell their students that by regularly
saving small amounts of money today it can become worth much
larger sums many years down the road. The reason for the
increase is known as compound interest. Stated simply,
compound interest is interest that is earned on the amount
of money invested, plus the money that is earned in future
periods on the interest earned. For example, if one were to
invest $1,000 at a 10 percent annual interest rate, the
investment would grow to $1,100 ($1,000 of initial
investment plus $100 in earned interest) at the end of the
first year. At the end of the second year, the account will
return another $100 (10 percent of the $1,000 initial
investment) PLUS an additional $10 (10 percent of the $100
in interest earned in the first year) for a total savings
account value of $1,210. The more times this process can
repeat itself, the better. The longer the investment has to
build interest, the more it will become worth.
When a
CD or savings account is advertised as paying a 5 percent
annual return, it will most likely yield the investor
something more than a straight 5 percent return. The 5
percent interest rate is stated as an annual rate, but banks
typically pay interest to account holders more than once a
year. If interest is paid to account holders once a month,
rather than once a year, the principles of compounding
interest come into play. Each month, the bank will pay
one-twelfth of the annual interest rate in interest to the
account holder on the investment PLUS on the earned interest
from previous periods. This results in actually earning
more than the stated annual interest rate over the year—the
actual return is known as the annual percentage yield (APY)
or effective annual return. For an annual interest rate of
5 percent, the APY, when interest is calculated monthly, is
approximately 5.12 percent.
Understanding the principles of compound interest not only
helps individuals understand how to accumulate wealth
through savings and investment over time, but also sends
warnings to consumers when borrowing money. Just as the
amounts of money returned to savers is typically greater
than the stated annual interest rates, so too are the
amounts of interest paid back to lenders when borrowing
money through loans and credit.
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