Interest is one of those topics that we often hear about when discussing financial planning. It usually seems more complicated than it actually is… and often, it’s hyped up far more than it should be.
We’ll discuss why in this article.
- What is interest
In simple terms, it’s a reward that the bank pays you for leaving your money with them. When you deposit money in a bank, the bank uses it for a variety of purposes from lending to investing.
You’ll often notice that the interest rates for deposits are far lower than the interest rate you pay when borrowing from the bank. This is one of the ways the bank makes its money.
For example. John may deposit $1000 in the bank which offers 1% interest compounded annually. So, in the first year, the bank pays John a whopping $10 in interest.
Now let’s assume that Mary takes a $1000 loan from the bank and is charged an interest rate of 8% per annum. In one year, Mary pays $80 in interest to the bank.
The bank takes $10 from her $80 and pays it to John… and the bank pockets the rest.
This is how it all works in simplest terms. Of course, there’s a lot more complexity to it, but now you have a basic understanding of what interest is and how it works.
- The problem with interest
Ever since time immemorial, banks have offered miserably low interest rates on savings accounts. In fact, these rates can’t even keep up with the rate of inflation which is always chipping away at the value of your money.
So, the old adage of saving and letting interest in the bank make you wealthy no longer applies. George Clayson’s book, The Richest Man In Babylon may be a little outdated here if you expect interest on your savings to generate wealth.
- Let’s talk about compounding interest
The financial gurus often speak of compound interest in hushed tones treating it as the be-all and end-all of wealth generation.
The truth is that compound interest is good, but you better be bringing some serious money to the table to get it to work for you. Either that, or you must be a teenager when you start saving up.
First, let’s see how compound interest works.
Remember the earlier example of John earning 1% interest compounded annually on his $1000?
In year 1, John will earn $10 in interest. You get this number by multiplying the principal amount by the interest rate.
In this case, 1000 x 0.01 = 10
At the end of year 1, John has $1,010 in his account. Compound interest will mean that now, the bank needs to pay John 1% on his $1,010. In other words, he’s earning interest on his principal and on his interest too.
This is what it will look like…
1010 x 0.01 = 10.10
Wow! He made 10 cents more than the previous year. Nothing to write home about, but you get the idea. When it gets to the higher numbers, the interest earned can be quite substantial.
- An easier way to calculate compound interest
One easy way to calculate compound interest is to use the ‘Rule of 72’. With this rule, you will divide 72 by the interest rate. To keep things simple, let’s assume your bank is offering you 9% interest on your money.
When we divide 72 by 9, we’ll get 8.
According to the Rule of 72, that means our money will double in 8 years at this interest rate.
Assuming we deposit $9,000 in the bank, in 8 years with the compounding interest, we’ll have $18,000.
8 years after that, we’ll double the 18K and have 36K in the bank. 8 years after that, it will be $72,000. So in 24 years, our $9,000 in savings has turned into $72,000.
Isn’t that fantastic?
It would be if banks offered such an interest rate… but they usually don’t.
So, if you really wish to grow your money, it’s best to invest in other financial instruments that pay out such attractive interest rates.
In fact, one of the best things you could invest in will be yourself. If you’ll educate yourself on starting a business and keep at it until your business succeeds, you may triple your money in less than half the time it would take if it were left to languish in the bank.
The velocity of money generates more profit. You need to make your money work for you.
Once you have saved an emergency fund and set aside some extra money in a timed deposit account, you’d be better off investing your money in more productive ventures.
Money loves speed… and to make it grow, you need to make bold moves. Bold, but not overly risky or foolhardy.
Once you’ve earned sufficient amounts that will actually rake in a sizeable interest, then you can deposit them in the bank and live off the interest if you want to.
For example, if you deposited $300,000 in a bank and they offered you just 4% interest, in 18 years, you’d have $600,000.
And in 36 years, you’d have 1.2 million dollars. That definitely sounds better than going from 9K to 72K over 24 years.
Like they say, money makes money. Now that you understand how compound interest works, use it as a tool when you’re ready to really rake in the interest. Until then, focus on earning as much as you can.