April is Financial Literacy Month, and our goal is to help you raise your money IQ. In this series, we'll tackle key economic concepts -- ones that affect your everyday finances and investments -- to help you make smarter choices with every dollar decision you face.
Today's term: compound interest.
The concept of interest is familiar to most of us. We know that with many bank accounts, for example, we earn some interest -- though it's rather paltry these days.
But there are several kinds of interest that are calculated and represented quite differently than simple interest. Compound interest is -- pardon the pun -- one of the more interesting ones.
First, let's start with simple interest. Here's how it works: Let's say that you've parked $1,000 in an account somewhere, earning 10 percent per year in simple interest. In year one, you'll collect $100, bringing your total to $1,100. Great, eh? In year two, you get... $100. That brings your total to $1,200. In year three, you're at $1,300. You're probably catching on to the idea by now. You keep earning that interest rate off your initial principal.
Small numbers become big numbers
Enter compound interest, which is far more exciting.
Start again with $1,000 and factor in an annual 10 percent compound interest rate. In year one, you get $100, for a total of $1,100. In year two, though, you collect that 10 percent not only on your original principal amount, but also on the interest you've already earned – on the whole $1,100. So you earn $110, instead of the $100 that simple interest gave you, bringing your total to $1,210. In year three, you collect $121 instead of $100, for a total of $1,331 instead of $1,300. In year four, you earn $133, bringing your total to $1,464 instead of the $1,400 you'd have earning simple interest.
The key thing to observe in this example is that not only is your overall total investment growing from year to year, but the amount by which it's growing is also increasing.
Now check out how powerful that 10 percent compound interest rate is over time, because when you combine compounding with years, the magic really happens:
$1,000 grows at 10% annually over...
Compound interest in your life
That kind of growth may seem magical, but it's not magic -- it's just math.
You don't need to wait around for an every-so-many-years environment of steep interest rates, either. If you invest in stocks or some other appreciating asset, your investment can compound over time even if it does not deliver the same return every single year. In that case, you'll be looking at an average rate of growth over time.
Over many decades, for example, the U.S. stock market has grown by an annual average of about 10 percent. Some periods it may average as little as 5 percent, and in others as much as 12 percent, but over long periods, it has generally grown.
There are other examples of compounding having a positive long-term effect. Knowledge, for example, builds on itself. The more you learn, the more you can learn. Once you understand some basics of biology, or French, or politics, you will be able to learn and understand more.
Of course there is a darker side of compounding, where ill effects compound. Epidemics are one example: Each infected person can infect more people, who can then infect even more people. Another dark side is the way your credit card debt can spiral out of control with hefty interest charges applied to an ever-growing balance due.
Focus on the positive, though, and put compounding to work for you in the best ways. Let it contribute to a comfortable retirement, for example. For that, you just need a solid expected growth rate and enough time.
Learning about some simple economic concepts can make you a better financial thinker and decision maker.
From taxes and credit to saving and money management, you can get lost in the complexity and abundance of financial issues. But by learning some simple fundamentals, you can take control of your finances and feel secure in your money management skills.
How well do you know the basics of personal finance?
Put your knowledge to the test with this 12-question quiz.
A. Under your mattress
D. Bank savings account
You want money you plan to use within the next three to five years to be safe and easily accessible. Lock it up in a savings or money market account. You won't earn much interest on it with rates so low, but you also won't lose any of it to the volatility of the stock market. You can find search for which accounts are offering the best rates on Bankrate.com.
A. Suck up to the boss
B. Get a second job
C. Adjust your tax withholding
If you typically get a tax refund each spring (and most of you do), file a new Form W-4 with your employer to increase the number of exemptions you claim - and lower the amount Uncle Sam takes from your paycheck. Try our easy-to-use tax withholding calculator to help you figure the right number for your situation.
A. Pay bills on time and keep credit-card balances low
B. Limit applications for new credit and keep old accounts open
C. Sweet-talk the credit-card company phone rep
The simple act of paying bills on time and keeping your balances low accounts for 65% of your credit score. New credit and the length of your credit history make up 25% of your score. The remaining 10% factors in the types of credit you use. Sorry, sweet-talking will get you nowhere.
A. Treasury bonds
B. Money market account
D. Residential real estate
Stocks fare best over long stretches of time. Take the 20-year period through 2012, for example. The average taxable U.S. money-market fund returned 2.8% annualized. Residential real estate, as measured by Standard & Poor's Case-Shiller index, did just slightly better with 3.0% annualized. Barclay's U.S. Treasury index earned 6.3% a year, on average. And the S&P 500 trumped them all, delivering 8.2% annualized.
A. Life insurance
B. Health insurance
C. Auto insurance
You only need life insurance if you have someone depending on you financially. Bob is unwed and childless, so he doesn't need it. However, he will need health insurance and auto insurance to protect himself against disaster.
B. 529 plan
C. Municipal bonds
D. Certificate of deposit
E. None of the above
A bank CD falls under federal protection if it's FDIC insured. That means up to $250,000 is protected in case a bank goes under, and you get up to $250,000 of insurance at each bank where you buy CDs. Municipal bonds, 529 plans, 401(k)s and other investments are not covered. You invest at your own risk.
Ashley, age 20, contributes $3,000 per year to an individual retirement account for ten years, then stops, letting her money sit in the account. Adam, age 30, contributes $3,000 each year to an IRA for 35 years. Who will have more money at age 65, assuming they get identical investment returns?
Ashley comes out ahead, thanks to the magic of compounding. Even though she stopped contributing after only ten years, her money will grow to about $694,000 by the time she retires, assuming an 8% annual return. Adam, who got a late start, but pitched in more money out of pocket, will amass about $558,000.
A. Your credit score
B. Your car make and model
C. Your car color
D. Your address
Insurers look at a variety of factors to calculate your risk, but the color of your car isn't one of them. Your financial habits, the type of car you drive and where you drive do matter.
A. At age 16
B. At age 18
C. When they get their first job
D. When their income reaches certain levels
A child's age or job has nothing to do with it. Rather, the IRS cares about how much the child made and the source of the income. For example, children who have investment income of more than $950 or have wage income of more than $5,950 in 2012 need to file a return. Children who receive a paycheck and have taxes withheld may want to file even if they don't have to - they could reclaim most or all of their income taxes.
You can withdraw contributions you made to a Roth IRA at any time, for any purpose without paying any taxes or penalties, and without having to pay it back - ever.
Any money you put into your Roth IRA is yours for the taking - even if you aren't retired. The money your account earns, however, cannot be touched until you're 59½ and have had a Roth for at least five years. Otherwise, you'll owe taxes and a 10% early withdrawal penalty on earnings. An exception: Once the money's been in your account for five years, you can tap your earnings to buy your first home.
B. Notify your bank and credit-card companies
C. Contact the credit bureaus
D. Call the Social Security office
Put your tears of frustration on hold. First, notify your credit-card companies and bank to monitor your accounts for fraudulent charges, just in case your wallet falls into the wrong hands. Second, contact the credit bureaus and put a fraud alert on your report. This will require lenders to make an effort to verify your identity before issuing new credit in your name. It also gives you a free copy of your credit report so you can review it for suspicious activity.
A. Upgrade your lifestyle: You've been pinching pennies for too long. It's time to reward yourself and live it up.
B. Maintain your lifestyle: Take this opportunity to pay off your high-interest debts and boost your savings. It's time to get ahead.
Sure, it's tempting to spend the money, but using it to strengthen your financial footing is the smarter choice that'll pay off exponentially in the long run.