Think about the money you spend each day on incidentals: a cup of coffee and a bagel at the Dunkin’ Donuts on your way to work, a sandwich and a Snapple at the deli at lunchtime, and a bottle of shampoo at the drugstore on your way back to work. Your friend calls after dinner, and you meet at Starbucks for a caffè latte. No big deal, it’s just an ordinary day. When you add it all up, though, you’ll see that this ordinary day cost you more than $15 in incidentals. Multiply the expenses for a typical workday by five, and you’re spending $75 a week on incidentals. By the end of the week, you have nothing to show for your spending but half a bottle of shampoo and a caffeine habit, and the weekend is just beginning. Of course, nobody is telling you to cut out all incidental spending. You do need shampoo, and coffee drinkers might argue that even shampoo is secondary to the Starbucks blend. But what if you cut that incidental spending in half? For instance, you could make your coffee at home and carry a sandwich to work. Would saving $25 a week make a difference in your long-term savings? You bet it would! If you saved that $25 each week, at the end of a year you’d have $1,300. Yeah, $1,300 is a lot of money, but maybe you’re still not convinced to cut back at Starbucks. If you invested the money at a 10 percent return, you’d quickly see that a penny saved is much more than a penny earned:
Investing $25 a week in a mutual fund with an average after-tax annual return of 10 percent (the historical stock market average) for 5 years would give you $8,400. Investing $25 a week in a mutual fund with an average after-tax annual return of 10 percent for 10 years would give you $22,300.
It’s hard to imagine that cutting out a cup of coffee and a sandwich each day can make that much of a difference to your savings, but it does. Interest, especially compound interest, can give you big returns on small investments. What’s the difference in types of interest, you ask? Let’s have a look. Simple interest, which is what we normally just refer to as interest, is a method of calculating what you earn on your money by applying the stated rate on only the actual balance on deposit for the exact period of deposit. For instance, if you invest $2,000 in an account for one year at 5 percent interest, the bank would pay you $100 at the end of the year. Not bad, huh? You get $100 just for letting your money sit there. But if you were earning compound interest on your $2,000, you’d be in even better shape. Compound interest is paid on an initial deposit plus any accumulated interest from period to period. Compound interest gives you interest on your interest. It’s definitely the way to invest. Compounding interest at 5 percent over a year wouldn’t make a great difference on a $2,000 deposit, but it still would give you a couple of dollars more for your money. When you get into big investments at higher interest rates, compounding interest really becomes significant. Interest is generally compounded in one of several ways: continuously, daily, weekly, monthly, quarterly, or annually. The more often it’s compounded, the better off you’ll be. Look for banks that compound interest continuously or daily. When your money starts growing, you’ll be pleasantly surprised. Sounds pretty amazing, doesn’t it? This is the power of compound interest and why a penny saved is a lot more than a penny earned.
