Compounding: How Savings and Time Can Add Up

You’ve probably heard the old adage “a penny saved is a penny earned.” Yet with wise investment planning and usually lots of time, it could be considerably more than a penny earned.

Why is this true? It’s because of the wonders that compounding can do for your finances. 

“Compounding might be the most underappreciated aspect of building a portfolio,” said Joe Correnti, senior vice president of brokerage product at Scottrade. “It’s simple but important math.”

How compounding works

Compounding is interest earned on top of the initial principal and any gains from things like stock appreciation or bank interest. Here’s a hypothetical example of how compounding works: Say you deposit $1,000 into an account that earns 5% annually. After year one, you have $1,050. After year two, you have $1,102.50. After year three, you have $1,157.63.* Each year, the dollar increase becomes larger as the 5% is added to a bigger pot of money.

The effects over the long-term

Maybe you look at the above example and say, “So what? That isn’t exactly going to allow me to retire tomorrow.” True. If your goal is to have enough money to retire tomorrow, you likely need to have that money on hand today. But if your plan is to accumulate wealth to match your investment goals, then compounding can have a profound impact, and you don’t need to be wealthy to get started.

And while you probably can’t control your rate of return, with time and consistent, disciplined savings, compounding can be a big ally for your portfolio.

Assume your goal is to retire in 30 years. Now let’s say you start with $25,000 and you add $6,000 on Jan. 1 of every year for 28 years. Assuming an average rate of return 6% (compounded annually), you would have about $571,000* in the account, even though you only invested $199,000.

The best way to take advantage of compounding interest is to start saving as early as possible. Let’s say in the last scenario, you saved for only 20 years. All else equal, you would have about $272,000,* less than half of what you could have with those extra 10 years.

Compounding’s downside

Compounding can work for you, and it can also work against you in the form of debt payments. Consider a student loan. If you have an unsubsidized federal loan, interest accrues once you receive the loan. Let’s say you take out $10,000 at the beginning of your freshman year and it accrues at an annual rate of 6%, compounded monthly. By the end of your 4 years in school, you will owe about $12,700.

The higher the interest rate, the more compounding can work against you. Credit card companies sometimes offer plans that allow people to suspend payments during times of financial hardship. But interest usually still accrues during that time, often at a high rate. So if you pay nothing for a long period of time, expect a larger monthly payment when you do start back up.

What to do: With all this in mind, it’s important to begin paying yourself as soon as you are able. Try to allocate a portion of each paycheck to savings.

Moreover, paying off high-interest debt as soon as possible can free up money to be spent elsewhere, including in ways that make compounding work for you.

Next Step: Check out our Investment Calculator to get an idea of how compound interest can work in your favor.

*Examples do not include the impact of taxes and commissions.

The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.

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