compound interest and why you should careIf you’ve been following GoGirl on Instagram, Twitter, Pinterest and Facebook you may have noticed we’ve been tagging pictures of our laudable financial decisions with the hashtag #CompoundInterest. Maybe you’ve been wondering why? Well, it’s for two reasons:

1. We want to publicly congratulating ourselves (and all of you) on savvy spending and saving – let’s encourage ourselves to keep fostering those good financial habits.

We don’t believe anyone should feel ashamed or meek about frugality; especially if it allows you to save more. As Manisha Thakor says, “putting some money aside is a form of self-care” and we are big on self-care.

2. While we’re patting ourselves on the back, we’re instilling an important financial lesson – the power of compound interest.

Even though we may only be saving a few dollars and cents per each good decision, if those dollars and cents are directed to our savings and investments accounts, where they earn interest and returns, the long-term outcome can be surprisingly good.

So, What the #hashtag is Compound Interest?

Compound interest is one of the most powerful tools for building wealth and everyone can benefit from it. It is the reason why saving early, and consistently, is so important as Compound Interest can have an even greater impact on your savings than the actual amount you save (the “principal”).

In its simplest terms, it is the principle of interest being earned upon the interest you earn upon the money you save.

Let’s Put Some Numbers on This!

You may be thinking “this sounds great, but I’m only saving $25 a month so a paltry bit of earned interest won’t really have an impact on my finances.” You’d be wrong!

Consider two people, Mary and Anya, who both save $25 each month in savings accounts that earn 6% in interest, computed annually. Mary starts saving her $25 per month at age 25 while Anya waits until she is 40. When they both reach age 60, Mary may only have saved $4,500 ($25 x 12 months x 15 years) more of her own money (the principal) than Anya did. However, her total savings will have reached almost $24,000 more! (Anya will have ~$12,000 whereas Mary will have ~$36,000).

This is because for each of those extra 15 years Mary was saving, the interest she earned earned interest and then that interest earned more interest, and on and on. To achieve the same level of savings, Anya would have had to have saved $900 per month from the age of 40.

If Mary had saved $50 per month and achieved an interest rate of 7% annually, by age 70, she would have almost $185,000 in total (considerably more than $36,000) despite only saving an additional $17,000 of her own money during that timeframe!

compound interest

Check out this calculator on Bankrate and input your own numbers to see the impact of different levels of savings and interest rates.

The Takeaways

The longer your time frame, the greater your contributions, and the higher your interest rate, the more of an impact compounding interest will have.

If you start saving later in life, you’re under pressure to save much more of your paycheck in order to end up with sizeable sums in the bank. This is why saving for retirement is something to be thinking about when you’re only 25 (or younger!) because as we’ve illustrated, you can achieve a lot more than you think, with a lot less than you think.

Bankrate has some great resources to help you find the best savings accounts however, at this point we should probably mention the elephant in the room – low interest rates! We’ve been in a low interest rate environment for several years now, and that looks set to continue for a while. However, all is not lost as it’s possible to achieve good returns via “keep-it-simple” investments such as index funds – Manisha Thakor explains more here.

When Compounding Becomes Your Foe

While, interest rates on savings aren’t so juicy, that doesn’t mean your credit card interest rate is almost zero (if you don’t know the rate, take a moment to check.)

So, this lesson in compounding is super important if you’re an avid credit card user. Just as compounding interest can work in your favor, it can also work against you – scarily. If you have credit card debt and are only paying the minimum payment each month, remember that the interest charged by your credit card provider each month is applied to both the principal (i.e. what you originally spent) and any interest that has accrued on the loan since.

In other words, whatever is left on your balance after you made the minimum payment will be subject to interest, and subject to interest again if you fail to pay down the whole balance in a subsequent month.  This is why it’s very important to avoid credit card debt. If you absolutely need to use your credit card for an emergency, find a card that has a low interest rate and, most importantly, work to make more than the minimum payment each month and pay the debt off entirely as soon as you can.

Share Your Savvy Spending and Saving

So join us on InstagramTwitterPinterest and Facebook and share your pat-on-the-back-warranting decisions with us using the hashtag #CompoundInterest. We’ll share them on to inspire others to do the same!