How do we grow our money? We all know that unfortunately, we can’t grow our money on trees. But there’s a way to have more money in the future. If we start saving early and make regular contributions to it each month in an interest-bearing account with a bank, our money will grow. I will prove how an economist would do it- you guessed it right, by using graphs and numbers!
For the younger generation, this post might be particularly useful. As soon as you start getting paid from your first-time job, whether it is a part-time job, or your first full-time job after college, you must learn to save for your future. American economy and many other economies nowadays are very consumption-based economies. People tend to live above their means and take loans to buy luxury things early on in their lives instead of saving money for the future. Our current generation needs to understand that there is no shortcut way to getting rich. Saving a portion of your income every month is key to having a secure financial future.
A very important factor for anyone’s wealth creation is to learn to start budgeting. Before you spend money on any of your expenditures, you must set aside some money to pay yourself first. By paying yourself, I mean depositing a fraction of your income in a bank account that pays you some interest.
Banks are considered low-risk and safe places to save your money. In the US, deposits at banks are insured by the Federal Deposit Insurance Corporation, FDIC. Deposits held at credit unions is administered through the National Credit Union Administration, NCUA. Your money is very safe in a savings account and is almost risk-free, hence the return paid on savings is not very high. Risk and return move together. It means higher the risk, higher the return, the lower the risk, the lower the return.
Inflation erodes money’s purchasing power, so keeping extra money sitting idle at your home is not a good option at all. A portion of your money should be either saved in a savings or time deposit account in a bank and some portion should be invested in high-return, high risk assets. In another post, I will go over where you can invest your savings besides keeping them in a bank. For now, our focus here is to understand how money grows with compound interest over time.
Just with the power of compounding, you can grow your money by a lot and a few years by just keeping it in a time deposit in a bank. Compound interest, or compounding, means that interest is earned on both the amount you initially deposit, which is called Principal, as well as on the interest you earn each day until you withdraw your deposits.
The rate of interest that the bank pays us is expressed as a percent. Two main factors will determine how fast money has grown when you withdraw your savings deposit. The first is the time component and the second is the rate of interest.
Mathematically, we can express this as
= P (1+i)t/ 100
Where P is called the Principal amount that we deposit initially in a bank
i is the nominal interest rate that the bank pays
t is the time period for how long we’re saving
I will explain this with a simple example. Let’s assume that I started saving at the age of 17 and initially deposited $1000 in a savings account with a bank at 3% interest rate and kept it for 20 years. Now each month, I started depositing $50 into my account. This means I have deposited $1000 + $12000 during the 20-year period. Are you curious to see what happens to my money in 20 years? With the power of compounding, my money has grown to be at $18,235.85. I magically made an extra $5235, which is $18235.85-$13000.
If I didn’t make a monthly contribution to my savings of $50, my money would have only grown to $1820.75 in 20 years. Thus, we see that the regular savings contribution is a very important factor in growing your money. Simply putting a certain amount of money into a bank savings account before you pay any bill or buy anything, will help a great deal in growing your money.
Now, if we assume that this time duration increases from 20 to 50 years with the same monthly contribution of $50 per month and the same initial deposit of $1000 when I retire at the age of 67, I will get $73,939.46. If I add my monthly contribution of $50 each month for these 50 years with the initial deposit of $1000. I would have contributed a total of $30,950 by age 67. This $43,000 got created just with the power of compounding.
If the interest rate goes up from 3% to 5%, and I keep saving $50 a month with the same initial deposit of $1000, my total money would become $145,551.98 at the end of 50 years. And I will be so happy.
Now, let’s change one variable of the equation, our time duration t. Let’s assume that instead of starting to save at the age of 17, I started saving at the age of 30. I want to show you the exact figure of how much less money I would be able to collect after 37 years. In this case, the total time is reduced from 50 years to 37 years and even though the rate of interest is higher at 5%. I will only have $70,360.49 instead of $145551.98.
Thus, by looking at all these examples, we understood that it is just not how much you save but also how early you start that will help your money to grow. The power of compound interest is making your money grow exponentially, doing the job for you. * For our math-savvy readers, did you notice that the time variable t appears as an exponent in the equation above and thus, shows the exponential rather than linear growth.
You just have to put your saving in a safe interest-bearing account such as CDs or time deposits with a bank and make routine contributions to it, and please start early. Once you have the job, you can get the money directly deposited from your paycheck each month into your account.
So yes, always remember to pay yourself first.
As I wrote earlier in my post, there are a few other options available in the market to save and invest your money. Some of these options can give us higher returns than banks do but they also pose higher risks as well. A recent article by Bankrate lists some savings and investment options in the US with no to very low risk. We will go over those in my next post.
