But compound interest is sort of exciting when you think about – it’s basically free money! You say that out loud; it’s going to turn some heads. The main difference is that compound interest is free money over time; not right away. Earning interest takes patience, but the pay off can be very rewarding, especially for young savers who have time on their side.
Look at this way – would you rather earn money with your blood, sweat and tears, or let your money do the hard work? That’s what interest on a savings account generally is, letting your money do the work for you. Let’s break down the what, how and why of compound interest and see if we can get you into a savings mindset.
What is compound interest?
The oft-used analogy to explain compound interest is to think of it as a snowball rolling down a hill. Your principal savings is the initial snowball and the compound interest is the snow it gathers, making it bigger and bigger until your bank account looks like a giant snowman.
And remember this snowball has accumulated snow without you needing to pack it on with your hands. Snow (your principal savings) is collecting more and more without you doing anything, other than letting it roll with time. And not only is your initial savings making you money, but the accruing interest (accumulating snow) is making you even more money.
Chart shows the power of compound interest, and how your savings (or debt) can accelerate over time.
What’s the difference between simple interest and compound interest?
Let’s toss aside snowball analogies for a second and look at simple interest vs. compound interest mathematically. Remember: compound interest is when the interest on your principal earns interest, and the interest on that earns interests, and etc. etc. Simple interest is just interest on the principle.
Here’s an example of compound interest:
Let’s say you have $1,000 in the bank with a 2% interest rate.
- After one year, you have will have $1,020 (1,000 + 2%)
- In two years, your balance will be $1040.40 ($1,020 + 2%)
- In three years, you’re looking at $1061.20 ($1,040.40 + 2%)
Notice that $1.20? It might not seem like much, but it’s the benefit of compound interest. Simple interest would give you 2% every year on your initial principal ($1,060 after three years). In other words, just an extra $20 every year. But compound is where you get that little extra $1.20, and it can really snowball overtime. Imagine this scenario over 30 years. With simple interest your savings would be worth $1,600, but compound interest makes it $1,811.36.
If you’re looking for an easy way to calculate compound interest check out Nerdwallet’s awesome compound interest calculator. It gives you the option to calculate interest frequency based on the month, day or year, plus other nifty features.
The Rule of 72
We’re always looking for ways to “double our money.” For whatever reason, it’s an easy mark of financial success, whether we’re talking about savings accounts, real estate or the blackjack table. The Rule of 72 is an easy way to determine how long it will take to double your money given a fixed annual interest rate using compound interest.
Here’s how it works: divide 72 by the annual rate of return and you’ll get an approximation of how many years it will take to double that initial investment. For example, 72 divided by a 5% annual interest rate equals 14.4. So, by that equation, it would take over 14 years for a $1,000 savings to become $2,000.
It’s not a perfect science (it would take slightly less than 14.4 years if you did the exact math), but it’s a handy go-to formula to get an idea of the power of compound interest and estimate the outcome of any growth rate.
Is there an average compound interest rate?
You will not find many banks offering simple interest savings accounts. It just wouldn’t compare against the competition, as compound interest will be preferred 99.9% of the time, and from the examples above you can see why.
Compound interest often offered as a yearly rate from the bank with interest delivered to you each month. For example, if you have a $20,000 savings with a 1% annual interest rate, you’re going to get monthly interest payments at around $16 ($200/12) for the first year.
Most interest rates from the big banks in Canada are on the lower side, around 1-2%, whereas the alternative online banks and credit unions can go higher (2-3%). If you are shopping around for a bank to start a savings account, check websites that compare rates, and find a financial institution that meets your needs in terms of convenience and a competitive interest rate.
The dark side of compound interest
We’ve talked about the wonders of compound interest and how a savings account can benefit you years from now, but we haven’t mentioned the evils of compound interest. That’s right, just like a Jedi Knight, “the Force” of compound interest can be used for the dark side – like debt!
Credit cards and loan debts both calculate compound interest on your balance, meaning if you miss payments the interest accrued will be charged interest, and on and on. It can be a vicious cycle and it’s thrown many people into a whirlpool of financial pain. It’s all the more reason to make your payments on time and avoid compound interest working against you.
One of the worse scenarios to be facing at the wrong end of compound interest is payday lenders. Called “predatory lending” by some, payday lenders charge obscene annual interest rates that can be as high as 442%! That’s like owing $17 for every $100 you borrow. It’s by far the most expensive way to borrow money. Avoid payday loans at all cost unless you are really in a pinch.
Start saving today for tomorrow
When you’re young, it’s easy to think you have all the time in the world before you need to start a savings account and prepare for the future. But then the years slip away, and you’re forced to play catch up. Use your youth to your advantage and let compound interest do its work as time passes on. Saving money is important, take it from financial legend Warren Buffet. He says, “Do not save what is left after spending; instead spend what is left after saving.”
Fresh Start Finance serves Canadians facing all types of credit situations with practical advice and credit-building solutions. We also offer quick-and-easy secured and unsecured installment loans to help you take those first steps to a better financial future. Apply today to see how we can help!