This week’s column continues our series of up-to-date tips and reports which will help a family prepare a reasonable, affordable financial plan with a goal of achieving financial freedom.
Savings is the first step of good money management. Making regular payments to yourself, even in small amounts, can add up over time. If you start saving your money in an interest-earning account, like a savings account at a bank or credit union, the amount of interest you’ll earn depends on three factors:
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Interest rate – the higher the interest rate, the more your money grows
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Time – how long you keep the money in the account will affect how your money grows. The more time your money has to grow, the better!
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Interest payments – how your bank pays you interest is very important. Almost all banks compound interest.
Interest
Interest is an amount of money banks or other financial institutions pay you for keeping money on deposit with them. It is expressed as a percentage and is calculated based on the amount of money in your account.
Here’s an example of your money not growing. If you have $1,000 stashed away under your mattress for a year, it will still be $1,000 at the end of the year, providing that it has not been lost or stolen. Your mattress is not paying you interest for keeping your money under it.
Compound interest
Compounding is how your money can grow when you keep it in a financial institution that pays interest. When the bank compounds the interest in your account, you earn money on the previously paid interest, in addition to the money in your account. But not all savings accounts are created equal. This is because interest can be compounded daily, monthly, or annually.
The tables below illustrate how compound interest works.
ANNUAL VS. DAILY COMPOUNDING
The more frequently interest compounds, the faster it grows.
|
ANNUAL COMPOUNDING |
DAILY COMPOUNDING |
| Start with $1,000At 5 percent, compounded annually.
At the end of the first day, still $1,000
At the end of the year, $1,050.00 – $50, or 5 percent of $1,000 added to the original deposit |
Start with $1,000At 5 percent, compounded daily.
At the end of the first day, $1,000.14 On the second day, add the interest earned, 14 cents, and compound the total amount – $1,000.14 At the end of the year, $1,051.27. compounding each day’s interest rate added to $1,000
|
| Total: $1,050.00 | Total: $1,051.27 |
COMPOUNDING INTEREST OVER TIME
|
5 years |
10 years |
|
| Mattress compounding –NO interest |
$1,000 |
$1,000 |
| Annual compounding at5 percent |
$1,276 |
$1,629 |
| Monthly compounding at5 percent |
$1,283 |
$1,649 |
| Daily compounding at5 percent |
$1,284 |
$1,649 |
