How Compound Interest Turns Small Deposits into Big Wins!

You’ve probably heard of compound interest, but do you really understand its power? In this article, we’ll break down the incredible benefits of compound interest when it comes to growing your savings. 

Compound interest is your best friend when it comes to saving money. However, it's the opposite when you’re on the other side of the equation, like with debt. Credit card companies know the power of compound interest, which is why they apply it to outstanding balances that aren’t paid off.

But today, we’re going to focus on the good side of compound interest - the way it can make your money grow.  

What is Compound Interest?

Compound interest is essentially earning interest on your interest. Here’s how it works: you earn interest on your initial deposit (and any future deposits), and then, year after year, that interest starts to accumulate on top of the previous interest.

In simple terms: you earn interest in Year 1 on your original deposit. In Year 2, you earn interest not just on your original deposit but also on the interest you earned in Year 1. This process continues each year as long as your money is in the account. 

The beauty of compound interest is that, over time, you end up earning more in interest than you actually deposited. That’s why the length of time your money is saved in a high-yield savings account is so important. The longer your money stays in the account, the more it works for you.

An Illustration of Compound Interest and Different Savings Strategies

Let’s look at two different individuals, both 20 years old, to see how compound interest works in practice.

First, meet Hindsight Harry.  Harry decides to wait until he is 40 to begin saving (20 years from now).  Next, we have Plan Ahead Patty, who begins saving money right away at age 20, though she contributes slightly less each month. 

Here’s how their savings play out:

• Hindsight Harry waits 20 years to start saving. He deposits an initial $10,000 and adds $500 monthly for the next 10 years. With an interest rate of 4%, after 10 years, Harry ends up with approximately $88,000. His contributions are $70,000, and interest earnings amount to $18,000.

• Plan Ahead Patty, on the other hand, starts saving immediately. She deposits $500 initially and contributes $150 per month for 30 years. With the same interest rate of 4%, Patty ends up with about $105,500 after 30 years. Her contributions are $54,500, and her interest earnings amount to $51,000.

As you can see, Plan Ahead Patty ends up with more in her account after 30 years, despite contributing less overall. Thanks to compound interest, she earned 2.8 times more in interest than Hindsight Harry, even though she saved less initially and each month.

Compound Interest is Essentially Passive!

One of the best things about compound interest is that it’s essentially passive income.  Once you make your initial deposit and set up automatic monthly contributions, your money works for you. The best part? You don’t have to actively manage it - you can just let it grow over time.   

Final Thoughts

As you saw from the example with Hindsight Harry and Plan Ahead Patty, the amount of time your money spends earning interest is so crucial. The longer you let your money work for you, the more you’ll benefit from compound interest.

To get the most out of compound interest, make sure your money is saved in a high-yield savings account. Traditional savings accounts often don’t offer competitive rates, so it’s worth comparing interest rates from different banks. If you do find a better rate elsewhere, consider moving some or all of your savings to that account. While you don’t want to chase rates constantly, monitoring them over time can ensure you’re maximizing your returns.