by Bob Ward
Compound interest is one of the most basic investment tools but it is either misunderstood or ignored by families trying to make the best of their budgets.
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Many families who are really struggling to stay afloat feel that savings are simply out of the question. However small the amount of savings may be, the savings process is still a worthwhile exercise as it encourages a thrifty mindset, which can be advantageous to all family members.
The key to achieving the benefits which compound interest has to offer is to re-invest the interest which you receive on a deposit and then not touch either the original investment or the reinvested interest until the deposit matures.
For example, if deposit yields an interest rate of 5% and the interest is re-invested over a period of 5 years, a deposit of $1000 would turn into $1276 at the end of the fifth year. On the other hand the saver can withdraw the annual interest of $50 and still have $1000 at the end of 5 years. The principle of compound interest not only applies to interest earning deposits but also to interest earning bank accounts. The same fundamental premise applies – don’t withdraw the interest you have earned rather leave it in the account to generate additional interest.
There is a rule known as the “Rule of 72” by which you can calculate, with the benefit of compound interest, how long it will take to double the value of your investment. You simply divide 72 by the relevant interest rate e.g. if the interest rate is 6% it will take 12 years for your $1000 deposit with compounding interest to grow to $2000. Conversely, if you are fortunate enough to achieve an interest rate of 12% the period would be 6 years.
Dividends can be re-invested in the companies which pay them rather than being paid in cash. It should be noted that not all companies offer this facility. Dividends are a different kettle of fish to interest on deposits and bank accounts. If you are going to continue to participate in dividend reinvestment programs you need to feel comfortable that the price of the shares involved is not going to decline. If you feel that it is likely to decline it is probably more prudent to bank the dividends involved and generate interest on them.
It is often a good idea to introduce children to compound interest at an early age as it could become the foundation for a savings and investing regime throughout their lives. The use of school based bank accounts is a great introduction to compound interest for children who have been known to become quite excited to see the interest, which they have earned, in black and white in their bank passbooks. One of the failings of the education system worldwide is the fact that school children are not taught the fundamental principles of personal finance which they need in later life. Parents can overcome this problem by freely discussing family financial issues with their children and there is no better place to start than a discussion about compound interest, as it is not difficult to grasp because of its mathematical basis.
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Copyright 2001 by Bob Ward. All rights reserved.