Compound Interest and the Power of Saving Essay

Compound Interest and the Power of Saving - Essay Example Interest in a nut shell is the cost of buying and selling money. The Banks buy money from you when you deposit money in the savings accounts or Certificate of Deposits at the Banks. The Banks give you a rate of interest on those accounts. But what do banks get out of that They then sell the money through loans and credit cards. So let us suppose the Banks give you 3% interest rate on the savings account and get 8% interest rate on a loan they give out. Essentially they make a profit of 5 % on that money. Now what is compounding of interest Simply put when interest is being paid on some money, that interest is added to the money and then the interest clock starts ticking on the new amount. Though it does not particularly sound exciting it is a very powerful concept and if utilized well can financially benefit anyone who understands it. To understand this concept an old parlor trick question can help. That question is, what would you prefer $1000 everyday for a month or a penny doubled everyday for the month (i.e. 1 cent the first day 2 cents the second day 4 cents the third day etc.). The mathematically astute person knows that this is a no contest and the person taking the penny doubling offer wins by a huge margin. The compound interest can be explained like this .Simple interest as we already know is the interest that is derived from only the investment in a principal amount. Say we take $100 and put it in an investment for one year at a simple interest rate of 10%. We multiply the interest rate of 10% times the principal amount of $100 to derive an interest payment of $10. This seems fairly obvious and straightforward. But let's look at what happens in the second year if the interest is not paid out. In a "compound" investment, the interest is not paid out to the holder; it is built up within the investment. Consider our $100 above. If the interest was paid out after the first year, we would get our $10 in interest and have our original $100 still invested. If the interest is not paid out, however, we would have our original principal of $100 plus $10 in interest for a total of $110 at the end of the first year. This entire amount would bear the original interest rate of 10% for the second year. Not only would we get 10% or $10.00 in interest on the original principal of $100, we would also get $1 which is 10% on the $10.00 interest from the first year. Our total interest received would be $11. This would continue into the third year. At the end of the second year, since we have not paid out any interest, we would start with our $110 from the end of the first year plus the $11 we earned in the second year. This would give us a third year opening balance of $121 which would bear interest of 10% for the third year. Our 10% interest on $121 equals $12.10. Assuming we still don't pay out any interest, we will now have a total investment of $133.10. Well it still does not look too exciting. But let us extrapolate this further. If we leave t his $100 alone for about 30 years we will end up with a $ 1000. Now that is interesting but definitely not exciting. Well how about this using the same mathematics if you save a $100 a week in thirty years that is One Million dollars. Now that without any doubt is exciting. But this sounds too good to be true, so the skeptic in me says that most likely in 30 years Million dollars would be