Compound interest, a Real Life example

I often talk about the need to save and invest over the long term and how you need to let your money work for you. While I think charts and grafts show this in great detail it is always nice to show how it works with a real life example. Some people need that tangible evidence, so here it is.

I was given a $100 savings bond thirty years ago as a gift. It cost $50.00 to the buyer. I held it for thirty years and just cashed in for $207.36 more than four times the original investment. That comes out to an average annual interest rate of about 4.86%. Historically over that period of time that is a pretty good rate of return for cash and everyone should have some cash or cash equivalents in their portfolio. See my post How much cash do I need.

While rates have gone up since that post, it is still a good idea to shop them occasionally to make sure you are getting the best rate. Just a small difference in a rate of return can have a huge impact over a long period of time. For instance if you have $10,000 in a savings account paying you the national average of 0.17% instead of the 1.45% you can get by shopping for an online bank it will cost you $128 in the first year. Why would you want to accept average anyway, don’t you deserve better than that?

Some people spend more time clipping coupons or driving a couple of extra miles to save a couple of bucks on gas or to save 50 cents to get milk on sale then it would take them to switch bank accounts and earn an extra $128.00. While I never understood why some people are not willing to invest just a little time to maximize their returns on their money, maybe this will help you. If you spend 30 minutes opening a better savings account online think of it as clipping a big coupon. Only this coupon gives back to you year after year, and it is not simply the $128 you would realize in year one. Due to the miracle of compound interest if you maintain that spread for thirty years the coupon will pay you almost $5,000! Now that is a coupon!

The miracle also works for your investment in the stock market although it is technically compound investment returns not interest. You would be surprised and how many people think they are a genius because they made money in the stock market the last couple of years. They were certainly wise to have their money in the stock market but almost anyone that had money in the stock market made money. You almost had to try to lose money if you were in the stock market the last several years. So I always give them credit for being in the market, but without a well thought out long term plan they may be losing out on even more money. It is not enough to just throw a dart at the stock market wall in an up market and say you have a good plan. Take that same $10,000 from above as an example. If you invest it at an average rate of 6% in thirty years you will have a little over $57,000 but if you get an average annual return of 8% you will have a little over $100,000. That is over a $43,000 difference on $10,000 investment just because of a 2% difference in your annual rate of return.

If you want to try assumptions based on different investment amounts or return rates down load this spread sheet to help you. The only thing you have to do is change the starting amount and interest rates at the top of each column and the spread sheet will do the rest. You can compare what 5 different rates of return will do to your investment over a 39 year period.