How many of you consider the effects of compound interest (or “compound returns”, if you prefer) when you make financial decisions? I mention the concept from time-to-time — and I've even devoted whole articles to the extraordinary power of compound interest — but I don't know if others keep the notion in mind when they work with their finances.
When I was younger, when I was struggling with money, I only had a fuzzy notion of how compound interest worked. Well, I knew how it worked, but it seemed abstract, as if it had no relevance to my own life.
Now, though, I often keep compounding in mind when I make financial decisions. As I make choices, I actually visualize little graphs in my head. (I'm a geek, what can I say?)
I was rummaging around Money Rates yesterday while researching my post on how to find the best bank accounts. During the process, I found an interesting compound interest infographic about how one percent can make a huge difference in retirement savings:
Click through to view the entire graphic.
This infographic does a great job of demonstrating just how powerful compounding can be — and how important it is to get the best rates possible:
By spending just a little effort to find the best interest rates, the Wynns keep their money working harder for them…The 1% difference in interest rates ended up giving them 38% more in annual retirement income!
As I've mentioned in the past, I'm not a rate-chaser. Not yet. But sometimes I wonder if I shouldn't be. Especially as I begin to build wealth, even one percent annually can make a huge difference in my nest egg. (Right now, it doesn't really make sense to chase the highest bank rates, either. Everyone's rates are low. But in a few years, as interest rates rise, I expect to see greater differentiation between various banks.)
This is also something I consider as I begin to invest more of my money. I understand that the historic returns of the stock market are about 10% annually. But I also know that average is not normal. Like everyone, I want the maximum possible investment return with the minimum possible risk. I know that if I can get 12% annually, I'll reach my goals more quickly than if I get 8% returns.
But I look at how many people were burned during the recent stock market crash, and it makes me think that the risk of reaching for 12% might not be worth it. With proper diversification, and by being conservative with my money, maybe I can obtain decent growth without risking my savings.
It's a tough balance to achieve because — as the Money Rates infographic show — one percent can make all the difference.
Author: J.D. Roth
In 2006, J.D. founded Get Rich Slowly to document his quest to get out of debt. Over time, he learned how to save and how to invest. Today, he's managed to reach early retirement! He wants to help you master your money — and your life. No scams. No gimmicks. Just smart money advice to help you reach your goals.