One of the main premises in David Chilton’s The Wealthy Barber is that individuals need to harness the power of compound interest. In other words, when you save money, you earn interest on those funds. In the following year, you earn interest on both your original principal as well as the interest earned. The magic of compound interest means that at an interest rate of 7%, your money doubles in about seven years.
Of course, The Wealthy Barber was published during a different era. Interest rates on things like high-interest savings accounts, savings bonds, and GICs were much higher than they are today. Today’s ultra-low rates makes it much harder, by comparison, for money to compound to the degree when rates were higher.
That’s the bad news. But the fact that interest rates are so low is even more of a reason to search out the best rates on savings products. If you’re not going to make a lot of money by saving, you should certainly find the best deal.
Consider the difference in putting $10,000 in either a regular savings account that pays 0.25% interest or a high-interest savings account paying 2%. In year one, the regular savings account will only pay you $25 in interest versus $200 for the high-interest account. You’re not striking it rich but the return is eight times higher with the high-interest savings account.
Let’s now assume you could stick with either account for a second year at the same interest rates. The regular savings account starts year two with $10,025 and earns another 0.25% interest, bringing the total to $10,050.06. Meanwhile, the high-interest account starts year two with $10,200 and earns another 2% interest, which brings its total to $10,404.
The different interest rates have a significant effect on the totals. While the interest on the beginning principal doesn’t change year to year for either account, the “interest on interest” works more in favour of the high-interest account. We can quantify this. For the regular savings account, the compound interest in year two only amounts to a paltry six cents, whereas for the high-interest account it’s a more substantial $4.
As the years go by, the higher-interest savings account pulls further and further ahead. Here’s how the first five years look like:
|End of year||Regular savings account||High-interest savings account|
Simple vs. compound interest
The above chart shows how much someone would earn after five years if they went with either the regular savings account at 0.25% or the high-interest savings account at 2%. As you can see, the high-interest savings account trounces the regular savings account by $915.18.
Most of the difference is due to “simple interest.” That’s the different rates of interest when multiplied by the beginning principal. However, compound interest certainly plays a role.
The regular savings account earned 0.25% in simple interest on $10,000 for five years. That’s five times $25, which equals $125. The total interest earned was $125.62 after five years, so the compound interest only amounted to 62 cents.
But it’s much more with the high-interest savings account. That account earned 2% in simple interest on $10,000 for five years or $1,000. The total interest earned was $11,040.80, meaning that $40.80 was earned in compound interest.
As we said at the outset, today’s interest rates preclude making a fortune off compound interest on savings products. However, if you choose the best interest rate, you’ll do much better than the typical savings account.
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Flickr: KMR Photography