Why Save?

"Those who understand compounding interest are destined to collect it. Those who don't are doomed to pay it."

We all know that saving money allows us to work toward larger purchases that we couldn't afford on a day-to-day basis. In addition to facilitating large purchases, saved money collects interest, which can amount to substantial earnings when compounded. In general, interest is the amount paid to a lender by a borrower for the use of the lender's money. If a bank lends you money in the form of a loan or if you use a credit card, they charge you a certain interest rate, say 10%. That 10% is the cost of borrowing money.

Similarly, when you keep money in a savings account, you are allowing the bank to use your money and the interest they pay on that account is, effectively, the amount you are charging them to use your money. So when you invest your money, either in a savings account, or in some other manner with a higher interest rate, you are making a profit on the original sum of money you invested, which is called the principal.

Simple interest is interest paid only on principal. If you deposit $100 in an account with a 5% annual simple interest rate, you will have $105 at the end of the first year, $110 at the end of the second year and $150 at the end of 10 years.

Compounding interest allows your investment to grow even faster by paying interest not only on the principal but also on previously earned interest. Most savings accounts compound interest monthly, though some may compound interest daily, weekly, semiannually or yearly.

As an example, assume that you invest $100 in an account that pays 5% annual interest, compounded monthly. At the end of one year you have $105.42. By leaving your money in this account, it continues collecting interest not only on the principal but also on the previous interest. You can calculate it by dividing the annual interest rate by 12 to find the monthly interest rate (If you want to calculate interest compounded weekly, divide by 52, semiannually, divide by 2, annually, don't divide at all). Then multiply that monthly rate by the principal to see how much you earn each month.

5% can be written as 0.05
0.05 / 12 = 0.0042 (0.42% monthly interest)

1st month

$100.00 (principal)
x 0.0042 (monthly interest rate)
100.42 (amount in account after 1 month)

2nd month

$100.42 (new principal)
x 1.0042
100.84 (amount in account after 2 months)

3rd month

$100.84 (new principal)
x 1.0042
101.26 (amount in account after 3 months)

For the next 10 years, the savings account will continue to grow as follows:

The example above assumes that you make no additional deposits in addition to the original $100. The results will obviously yield even higher returns if you continue to deposit more money into the account regularly.

The role of compounding interest demonstrated above is sometimes referred to as the time value of money. This is the relationship of time, money and rate of interest, and their impact on savings growth. As shown above, a dollar received today is not equal to a dollar received in the future because you can invest today's dollar and earn interest. Your investment can then earn a positive return in excess of your original dollar.

Are you paying or collecting?
The principle of compounding interest works the same when you save, as when you take a loan or keep a balance on a credit card—the only difference is who is making the interest and who is paying it. So, when you borrow money by using a credit card and don't pay the whole thing off, you are charged interest. The following month, the interest you were charged will be charged interest as well, and so on. When you invest or save money (and don't touch it), your deposits earn interest, and then the interest earned on those deposits also earns interest. That simple concept accelerates the whole process quite a bit and either makes you—or costs you—money.

   [ Next ] Developing a Savings Plan