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The power of compound interest October 1, 2008

Filed under: Everything — Jason Olson @ 5:55 pm
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As we evaluate the collapse of the mortgage market, we see the power of compound interest, and what happens when the interest rate increases. However, recently while at the bank, I made a transfer into our son’s Coverdel Savings Account. Check this out. We have both a regular savings account, 3.02% APR, and a Coverdel Savings Account on a 2-year CD @ 5.02%. If we left his current balance at $500 and never changed it (and presuming the interest rates stay the same), over the next 20 years, before he is ready for college, the same $500 will grow to $910 and $1356 respectively. So, you can see that the simple difference of 2% yields a double rate of return. $410 growth, versus $856!

Take a simple investment of $10 per month, so $500 base, plus $10 per month over 20 years – a total cash investment of $2900 yields $5483 – or $2583 of interest – a 89% return on investment!!!

Not a bad place to put your money.

Then again, before you start looking too quickly into this method, it is more essential that you pay down any sort of revolving credit you may have – it really doesn’t matter much if you’re putting away $5 per month @ 5% compounding interest, if your credit card has more than a 5% interest rate and you owe more than $5! In that case, putting money in any sort of savings would yield a negative rate of return… Your debt would exceed your savings.

Although if you’re near maxing out your credit, it may be worth to try to save small just so you have an emergency fund, but any sort of long term savings should be held until you have your credit cards paid in full monthly.

A second exception to this would be any place your savings can work for you at a rate better than your credit cards. An excellent example would be a matching 401(k) program – if you’re employer matches you dollar-for-dollar, then you receive a 100% ROI, and that is then further increased by your investment. In this case, as best possible, maximize your 401(k) and then evaluate how it might be leverages to pay down your revolving credit.