Many news stories and advisors lately seem to focus investment strategies as a surefire way for people to gain extra income, almost to the point of neglecting savings accounts. Savings accounts aren’t the sexiest way to become financially sound, it’s true. They don’t have the sheen and allure and risk that go along with investments, but they’re one of the most important pieces contributing to financial security. And, if you’re able to calculate compound returns from regular savings, you’ll have a great foundation for incorporating other strategies as well.
Let’s begin at the basics: when you open a savings account, your account will gain interest relative to the deposits, balance and length of time it has been established. The higher the number is for all of those things equals the higher the interest accrual will be, too. Where things get interest is when you’re able to take advantage of compounding returns, or where the interest is paid on both the principal amount and accrued interest.
It might not sound like the most exciting thing in the world, but let’s look at a few examples:
- You put $1,000 into a savings account that earns 3% interest each year. After the first year you have would have earned $30 in interest, so the account balance would be $1,030 (3% multiplied by $1,000).
- In the second year, you earn $30.90 in interest, $30 in interest on the $1,000 deposited and $0.90 on the $30 in interest she earned last year. If you had taken out the interest received in year one, then you would have missed out on the $0.90 in interest in year two.
- In year three, not only do you get to earn interest on the original $1,000, but you also earn interest on the $30 earned in year one. Now you earn interest on the $30.90 earned in year two.
With no added deposits and after a decade, the balance would be around $1,343. If that $30 was withdrawn every year, then you would only have $300 in cash and the $1,000 in the account. Over the course of 30 years, that amount explodes into $527. And if you were to add just a few dollars every month, it’s even more drastic.
The key things to take away from this are just how important it is to understand compounding returns as well as the importance of starting early and often. If you’re able to apply these mechanics to your retirement account, for example, your future self will thank you. J.D. Roth’s post on how compound returns favor the young includes a spreadsheet that can show how the money accumulates and how to put a plan in place for yourself. But it’s never too late to start taking advantage of these types of returns!
And, once you’ve established a growing fund, it’s time to start investing. How do compound returns figure into your savings and/or investment strategies?