For the sake of argument, let’s say you have $1000 in your bank savings account. Let’s further assume that your money is earning 1.00% Interest. As crazy as it may seem, that is a good rate for a savings account in the 2017 market. Interest rates for savings accounts are at rock bottom. We’ll use this meager return as an example of why the Magic of Compounding Interest is both impressive and desirable.
How The Magic Works
In a simple world where math is infrequent and universally disdained, you would simply let your money sit in the savings account, and, at the end of the year, the bank would deposit $10 interest into your account. In that simple case, you would then have $1,010 in your savings account. In that scenario, your gains are due to simple interest, which the bank only pays on the principal (your original $1000). The mathematical complexity arises when we consider that banks usually don’t work like that. More often than not, you make money on your principal as well as on the interest that you have already earned. That is what Jim Cramer would call a “high-quality problem!”
When banks pay interest on the principal plus the interest already earned, we call it compounding. When choosing an account, it is important to know how often the bank compounds the interest. As a general rule, the more frequently the bank compounds your interest, the faster your money will grow. Some banks compound daily, while others do so monthly or quarterly. Obviously, I’d prefer my money to make me money every day and not just once per month or once per quarter. Note that this works against you when you hold credit card debt; most credit card companies compound what you owe them daily. In the case of daily compounding, your money will earn 1/365th of the 1% annual rate each day you leave it alone and let it grown. This quirky calendar may sound like a small detail, but over a ten year period, daily compounding can add about 10% more profit than you would earn with simple interest.
Savings Accounts are Terrible Investments
At the end of 10 years, then, your $1,000 investment would grow to an immense value of $1,105.17 with compound interest. Even with the miracle of compounding interest, that is still depressing. There are two lessons here. The first may not be so obvious: Compounding interest is amazing, and you want every dime you can get invested so it can contribute to the compounding process that will make you wealthy. The second lesson is that 1% is a terrible rate of return, and you will never grow rich tucking your money away in a bank savings account.
In reality, the only reason to use a savings account is the psychological barrier it places between you and your money. Most people have trouble letting cash sit in a checking account without dipping into it. You absolutely must have an emergency fund that you will not touch except in a bona fide emergency, and most of us have the discipline not to rob our emergency fund if it is walled off from our ATM card by a savings account. Why do we not invest it in equities so it can compound? The reason is what money managers call liquidity. You need your emergency fund hidden away psychologically so that you do not raid it, but you need to be able to access the cash quickly when an emergency arises. If your money is in your investment account, the market may be down, or it may take several days to transfer the money into your savings account.