When you save money today, you do not see that much benefit in saving right away. Worse yet, you even have to give up something, rarely the chance to buy stuff today with the money you are saving. Fortunately you get something in return for saving and not spending today. You receive interest on your savings. One of the most powerful and underestimated features of this interest rate is the fact that you get interest every year. At some point, when you have already received interest on your initial savings, you will also receive interest on that interest income. This is called "compound" interest. To get a better idea, how the savings can add up in this way, let's look at a couple of examples.
Say you put away $ 10,000 and you do not touch that money for 10 years. Let's assume you get an interest rate of 7% during that time period. Your $ 10,000 will grow to almost $ 20,000 over that time, mainly due to compound interest. At the end of the first year you have $ 10,700, but then you gain interest on that extra $ 700 for 9 more years. The second year your total savings are $ 11,449. Now you can earn 7% interest on the $ 1,449 for 8 more years. Let's say you keep the money for 20 years, you will most likely receive a higher rate of return, let's say 8.5%. (When you agree to save for a longer period of time, you can usually find higher returns on your dollars). If you save longer at that higher rate, you will have more than $ 50,000 in the bank after 20 years. Today's savings actually amount to quite a bit of money, if you wait long enough.
Let's look at another example. Instead of putting $ 10,000 away today, say you save $ 500 each month and every month for the next 10 years. Again, we assume that you receive a 7% return on that $ 500 you put away every month. After 10 years you would have over $ 85,500 in the bank. If you do that for 20 years and you get an 8.5% return, you will have over $ 300,000 in the bank. All that with monthly savings of $ 500! Not so bad, right?
As you can see, your savings can grow quite a bit over time!
Source by Vilna Treitler