If you’re new to the idea of investing, you may wonder what the big difference is between investing your money versus simply saving your money. The biggest factor between the two is known as Compound Interest, and this factor can add a significant amount of money to your savings. First, let’s revisit our definitions of Saving and Investing found here:
- Saving (+): Saving is setting aside a portion of the money that you have been paid for the value that you have created. It can be thought of as “Addition” since you are adding to your money for a specific purpose. Saving also provides a defense against unexpected events as well as a defense against having to go into debt to cover large purchases. In short, saving helps keep you free.
- Invest (x): If saving can be thought of as “Addition” then investing can be thought of as “Multiplication.” It’s simply using some of the value that you have set aside through saving to create even more value, more quickly than simply saving could.
Compound Interest Working For You
The multiplication effect that allows you to turn value into even more value is Compound Interest. Compound Interest is simply interest on top of interest, or in other words, money you’ve gained through an investment being used to gain even more money from that investment. Over time, the money gained through interest can become even larger than the initial money (known as “Principal”) that you’ve put into your investment. Let’s take a couple quick examples to illustrate:
Example #1: Sam the Saver decides to diligently save $4,000 every year. After 20 years, Sam has accumulated $80,000.
Example #2: Ivan the Investor also decides to diligently save $4,000 every year for 20 years, but invests in a Stock Index Fund which averages a yield of 7% over 20 years. Ivan not only accumulates $80,000 in Principal (Savings), but also accumulates an additional $95,000 in Interest, for a total of over $175,000.
Clearly Ivan benefited from the phenomenon of Compound Interest, more than doubling his money over 20 years through investing.
Does this mean that all of your money should be invested in stocks? No, and that’s why this is simply an illustrative example. If you have saved up money for emergencies or for an important purchase such as a house, then the short-term investment risk of something like stocks may be unwise since you could actually lose some or your money before you need to use it. But, you could still take advantage of Compound Interest at lower rates through High Yield Savings Accounts or Certificates of Deposits (CDs). For any savings beyond what’s needed for emergencies or important purchases (meaning, any savings that you can afford to be a bit more risky with), investing such as Ivan did over the long-term is historically a great move.
Compound Interest Working Against You
Just like Compound Interest can work for you, it can also work against you in the form of interest on debt. Interest on debt is a normal cost of borrowing money, and it can be well worth it for short-term emergencies or purchases such as a house or a car, although paying in cash is always the ideal route instead of borrowing. However, trouble really begins when you borrow money at high interest rates and fail to pay this money back quickly (trust me, I know :-)). Annual Interest Rates on credit cards, for example, can still be as high as 9% even for borrowers with excellent credit. For borrowers with average credit or bad credit, interest rates can easily be between 15% and up to 24% or worse. The effects of holding debt at these rates will quickly work against your money growth efforts – Instead of having your own money work for you, you are working for the privilege of holding someone else’s money!
The effects of compound interest on credit card debt are not only worse because of the high interest rates, but also because interest on credit card balances is usually compounded daily, not monthly or yearly, which means your borrowing is working even more quickly against you then you might assume. How bad can it get? Business Insider has a great example of how a balance of just $5,000 can yield interest payments of over $44,000 after 10 years here.
Compound Interest is a wonderful phenomenon, if used in your favor. Be sure not to throw away money in the form of credit card interest. Instead, quickly pay off high interest credit card debt if you have any and work towards taking advantage of the effects of Compound Interest to amplify your money growth efforts through investing.