When Benjamin Franklin died in 1790, he left $ 5,000 each to the cities of Boston and Philadelphia. Each city was to create a fund that would last 200 years. The needy could borrow from the fund at an interest rate of 5%. After 100 years, each city could withdraw $ 500,000 from the fund, leaving the rest to work for the next 100 years. Why did Franklin do it? Help people understand the importance of compound interest.
What is compound interest? It is interest that earns interest. For example, suppose you saved and banked $ 100 a year ago. He earned $ 2 in interest last year. This year, you will earn interest on $ 102 (original savings plus interest earned). It may not seem like much, but understanding this simple fact can have a major impact on your financial success.
Why is Compound Interest Important to You? Because he can turn a few dollars today into big bucks over the course of a lifetime. Let’s take a look at the 10 facts you need to know about compound interest:
1. Anyone Can Benefit From Compound Interest. You don’t have to be a Wall Street Magician or a Harvard MBA. Almost all investments will earn compound interest if you leave income in the account.
2. Compound interest is a double-edged sword. This is fine if you regularly save money, but it can be cruel if you borrow money.
3. You want your savings to be compounded as often as possible. It’s better if you dial quarterly rather than annually when saving money. If you borrow, the exact opposite applies.
4. Time is on your side. The more money is made up, the faster it grows. Money that grows at 6% per year will double in about 12 years, but it will be worth four times as much in 24 years.
5. Time is not on your side. Credit cards and other open accounts use compound interest against you. That’s why “minimum payments” will likely keep you in debt forever.
6. Don’t be put off by today’s low interest rates. It is true that banks pay little on savings accounts. But many mutual funds have, on average, a higher return and have very low minimums and no sales charges. If you can’t put a few dollars into your savings, most debt (think home or credit cards) will allow you to add any amount to your payment.
7. It adds up faster than you think. If you were to save $ 5 per month you would earn 5% compound interest each month and with that continuously for 10 years you would have put $ 600 in savings. But the account would be worth $ 776. And, even if you didn’t add a single penny, it would be worth over $ 1,500 in 15 years.
8. Compound interest can free you from credit cards. Suppose your interest rate is 14% and you add only $ 5 per month to your payment. In 10 years, you will avoid $ 1,315 in payments.
9. You don’t have to be rich for compound interest to work for you. Principal works the same whether you have invested $ 100 million or $ 100 million. The millionaire may have more investment options, but even the poorest of us can use compound interest to reduce the amount we pay credit card companies and payday lenders.
10. Compound interest forces you to sacrifice today to reap an advantage tomorrow. It is true that you will have to do something to save a few dollars today. But, it is certain that the future reward will be greater than the sacrifice.
What is the result for consumers? Often the difference between financial comfort and poverty is not that great. Saving a few dollars a week might not seem like much, but if done regularly, it could make a big difference in your financial future.
Gary Foreman is a former financial planner who founded The Dollar Stretcher.com website. The site has many topics on personal finance, including more information on Compound Interest for the Poor.