Understanding Compounding Interest on Your Investments - dummies

Understanding Compounding Interest on Your Investments

Over time, a modest-but-steady rate of compound interest can build into a sizable nest egg. The most powerful investments have stable, compounded returns. Regardless of what’s happening in the economy or stock market, you can always count on the magic of compounding.

Simple interest is a return that your financial institution pays you based on a certain percentage of every dollar you put aside in your savings account. For example, if you have $1,000 in your account (called principal), and the bank pays 2.5 percent annual interest, then you receive 2.5 cents for every dollar that was in your savings account for the entire year. After 12 months, you accrue an additional $25 in your savings account.

Savings accounts are the most familiar type of fixed-income investment, and they provide

  • Substantial safety for the principal balance

  • Low probability of failure to receive earned interest

  • High liquidity

One drawback to savings accounts is that returns (the amount of money you earn for giving up the immediate use of your money) often are the lowest available. A savings account is a classic example of a low-risk and low-return investment. Want to check out how much and how fast your savings can grow? Try the calculators at these Web sites:

  • FinanCenter features an online calculator that determines how much your money can earn. You can use this calculator to figure out how much money you’ll have at some future date or how long it will take to reach a predetermined savings goal. On this Web site’s home page, click on Our Products, then Calculators, then (under Calculator Categories) on Savings, and then on What will it take to become a millionaire?

  • CNNMoney provides a savings calculator to determine how fast your savings can grow depending on an interest rate, initial deposit, and additional payments. Go to CNN Money home page and click on Calculators in the left margin. Select the Savings Calculator.

Okay, so now you’re wondering just how long it takes to double your money. The Rule of 72 is a quick and dirty way to calculate your rate of return without using an online savings calculator. Simply divide the rate of return (interest rate) on your savings into 72. That gives you an estimate of how long it takes for your investment to double in value. An investment earning 6 percent annually, for example, doubles in 12 years (72 ÷ 6).