cepp_logo5.gif (13296 bytes)


newspaper.gif (867 bytes)

<Back to Articles Page

The following article was written by Coleman Patterson and appeared in the Business section of the Abilene Reporter-News.

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.

<Back to Articles Page

reporternews.gif (5314 bytes)

© 2006, 2007, 2008  Coleman Patterson, All Rights Reserved