How to Use the Power of Compound Interest to Grow Your Savings

Let’s face it: saving money can feel like a slow, uphill battle. Every dollar feels like a sacrifice, and it can be hard to see the long-term benefits. But there's a secret weapon that can transform your savings journey – and it’s free! That weapon is compound interest.

What is Compound Interest?

Simply put, compound interest is earning interest on your interest. It’s a snowball effect. When you initially deposit money into an account, you earn interest on that principal. But then, the next time interest is calculated, it’s based not just on the original amount, but also on the accumulated interest.

Let's look at a simple example:

Year 1: You invest $1,000 at a 5% annual interest rate. You earn$ 50 in interest ( $1,000 x 0.05). Your total is now$ 1,050.
Year 2: You earn interest on $1,050. At 5%, you earn$ 52.50. Your total is now $1,102.50.
Year 3: You earn interest on $1,102.50, which is$ 55.13. Your total is now $1,157.63.

As you can see, the amount of interest earned grows significantly over time. This is the power of compounding!

The Magic Numbers: Time and Rate

Two key factors dramatically influence the impact of compound interest:

Time: The longer your money is invested, the more time it has to compound. Even small differences in time can lead to massive differences in the final amount.
Rate: A higher interest rate will accelerate the compounding process. However, it's important to remember that higher rates often come with higher risk.

How to Maximize Compound Interest in 2020 (and Beyond!)

Here are some practical steps you can take to harness the power of compound interest:

Start Early: The earlier you start saving, the better. Even small contributions made early in life can grow into substantial sums over decades.
Take Advantage of High-Yield Savings Accounts (HYSAs): HYSAs offer significantly higher interest rates than traditional savings accounts. Online banks often offer the most competitive rates.
Consider Investing (with Caution): While HYSAs are great for short-term savings, for longer-term goals, investing in stocks, bonds, or mutual funds can offer potentially higher returns. However, investing involves risk, so it’s crucial to understand your risk tolerance and diversify your portfolio. Talk to a financial advisor if you need help.
Automate Your Savings: Set up automatic transfers from your checking account to your savings account. This ‘pay yourself first’ approach makes saving a habit and ensures you’re consistently compounding interest.
Don’t Be Afraid of Small Amounts: Every little bit helps! Even contributing $25 or$ 50 per month can make a difference over time.

Resources to Explore:

Bankrate HYSAs: https://www.bankrate.com/savings/high-yield-savings-accounts/
Investopedia - Compound Interest: https://www.investopedia.com/terms/c/compound-interest.asp