When people talk about the power of saving, they often emphasize the importance of interest. Interest is the gains you make on your money just for leaving it in an account, and there are multiple kinds of interest. The most interesting of these (by far) is compound interest.
Compound interest/earnings is a term given to describe a situation wherein you’ve invested money, it has gained interest, and you now get to gain on the initial investment PLUS that interest. As you can probably imagine, this has the potential for huge growth of a savings account.
Let’s look at an example of how powerful this rule is. If you’ve entered an investment situation where the interest per year is 7%, you’ll be able to double that investment in ten years. Similarly, if you’ve been fortunate enough to enter an investment wherein the interest is 14.5% per year, it will only take you five years to double your investment.
Obviously this effect will seem more dramatic the more money you’ve invested. If you’ve invested $100,000, you’re going to feel the effects a lot more than if you’ve invested $500, but both represent growth that could not happen if you had merely left them in a savings account.
If you want to see an example of this you’re likely already experiencing, take a look at your superannuation account. What’s your balance today as compared to five years ago? What could it have been if you’d deposited just a little more?
The awesome thing about these investments is that the more you invest over time, the more the money continues to grow. Little by little or chunk by chunk.
The rule of 72
Investors often refer to the investing principle called “the rule of 72” when trying to illustrate the power of compound interest. We’re going to walk you through it now so that, no matter what your experience level, you’ll have a firm understanding of just how incredible this principle is.
Step 1) Take the number 72
Step 2) Find the common rate of return (that you might get) on an investment you’re considering
Step 3) Divide 72 by the rate of return
The number that results is the number of years which you need to invest if you want to double your investment.
If you had the option to double your money in five, maybe even ten years, why wouldn’t you give it a try? The alternative of leaving the money in a low interest savings account likely looks a lot less competitive now that you’ve seen the power of compound interest. Do some examples with the rule of 72 if you need any more encouragement!
72 divided by 7 (7% rate of return) = 10.2 years to double your money
The higher the interest rate, the quicker the compounding effect.