Investing For Your Future
Monthly IFYF Investment Message
January 2007
Back to Archived Monthly Investing Messages.
Happy New Year's greetings from the Cooperative Extension System, developers of the Investing For Your Future home study course and Web site. Best wishes for good health and increased wealth during 2007.
The start of a new year is a good time to consider the awesome power that compound interest has on investment returns over time. Simply stated, compound interest is interest earned on the original amount that someone saves/invests (called principal), plus the interest earned on that interest. As the American Savings Education Council (www.asec.org) notes in one of its publications, "this phenomenon goes on and on-packing your savings with power and moving you steadily toward your goals. Over time, the results can be dramatic."
In the Investing For Your Future home study course, readers are introduced to the Rule of 72. This guideline is useful for understanding compound interest because it shows the approximate time or interest rate required to double a sum of money (e.g., $2,500 to $5,000). To apply the Rule of 72 to your own personal investments, you need to know or assume their expected rate of return. For example, you may own a bond that you know will regularly pay 6% interest until maturity or assume that the average annual return on your stocks is 8%. Then simply divide 72 by the known or assumed interest rate. For example, at a 6% interest rate, money will double in approximately 12 years (72/6). At 8% interest, the doubling period is shorter, 9 years (72/8).
You can also calculate the Rule of 72 with the doubling time as the assumed variable. Simply divide that number into 72 to calculate the interest rate required to double your money within that time frame. For example, if you want to double your money in 10 years, you'll need to earn about a 7% average annual return (72 divided by 10 = 7.2).
Compound interest works best with time on your side, especially in tax-deferred, growth-oriented investments, such as growth mutual funds placed in an individual retirement account (IRA) or 401(k). The longer your money is invested, the more compound interest works for you and the less you need to save on your own. In tax-deferred accounts, investment earnings are not taxed until withdrawal, usually at retirement. The longer investment returns grow free of taxes, the more time compound interest has to work its magic. A third important factor that helps compound interest grow money over time is automation; i.e., having investment deposits taken directly from someone's paycheck or bank account and placed into an investment product.
Compound interest has been called "the eighth wonder of the world" because of its tremendous ability to grow money over time. Small wonder....even small initial deposits make a difference when they are given decades to grow. Much like the television game show Who Wants to Be a Millionaire?, money will double slowly in the early rounds (decades) of investing until it grows to a larger sum that will double much faster after someone has been in the (investing) "game" for a while. Many people simply don't realize the awesome power of compound interest and underestimate their ability to become millionaires during their working years...without winning a state lottery or receiving some other type of windfall.
For further information about compound interest, download the American Savings Education Council's brochure, The Magic of Compounding, from www.choosetosave.org.
