Two words lie at the heart of understanding why: Compound interest. Let us first look at examples we understand, before applying the same principal to savings. In order to avoid complicating the figures, we will work with round numbers.
Let’s say we have a credit card on which we have borrowed $1,000. The interest rate of this card is a typical interest rate of 20%. For this example, to avoid complications, we shall assume the period of time is one year, and that no further debt is drawn on the card and only the minimum payment of $30 is met. Interest is added at the end of each month not based on the original $1,000 but based on the original $1,000 plus the previous months interest. So $1,000 will accrue $16.60 interest at the end of the first month, making the debt $1,016.60. Of that we repay $30, making the new total $980.60. The second month, the interest is calculated on that $980.60 – we are paying more than the interest, but not by much. At this rate it will take ten years to pay off both the interest and the original capital sum, during which time we will have paid $990 in interest – a good deal for the bank, It has got back nearly twice what it lent out; not so good for the borrower. Again, these figures are vastly simplified but they do show that compound interest can vastly grow the amount from the original principal to something much bigger.
Naturally, banks don’t give a customer anywhere near the level of interest rates as they charge. On average, for tax free accounts the interest is between 1.7% and 2.2%, for accounts liable to tax this is reduced to between 0.9% and 1.3%. This does not sound much at all, but let’s now apply it in principle.
Let’s take our $1,000 but this time it’s in a 2% high interest account. Assuming we don’t add anything at all to it, after ten years it will have become $1221.20 – so we have made $221.20 for an initial investment without any further costs. Should we have a regular savings plan, let’s say putting away a further $10 a month during that ten year period, the savings now equal over $2,500.
Most financial planners recommend putting away at least 5% of your monthly income a month as savings. Let’s say that a couple has a combined income of $60,000 per annum, and they put away half that – $1500 – a month over ten years, starting with nothing. At a 2% interest rate, this means that at the end of ten years they will have a savings account with $16,600 in it. A huge investment should the unexpected happen.
Now let’s say they are both 30 when they start saving, and both retire at 65. That’s 35 years of savings, which gives them a retirement nest egg of $61,693 of which $16,693 is pure interest. Should they have put away the 5% recommended amount, instead of half of it, their savings would be $123,386 of which $33,386 would have been interest.
While this doesn’t come close to pension plans – companies can, after all, get a better interest rate on their plans than an individual – this amount of over one hundred thousand dollars is a lot of money; with that they could easily settle anything outstanding on a mortgage or live relatively comfortably for many years. Savings accounts are not intended to replace pensions, nor should they be – but a couple paying into a savings account on a regular basis can have a large supplementary “nest egg” for holidays, buying a car or sending children or even grandchildren off to university.
As a final note it’s worth investigating child savings accounts as quickly as possible, since these accounts offer much higher rates of interest – up to 5% – until the child reaches the age of majority, and thus are much better prospects for investment for a growing family than using the parents high interest accounts which may accrue only half as much interest. Not only does it teach the children fiscal responsibility from an early age, as they can be encouraged to pay pocket money into the account to boost the savings, but it guarantees a sum of money the child would not otherwise have, due to them right at the time when they will be considering university. This could be make or break where calculating university fees and consequent student debt are concerned.
There are many financial calculators available on the internet. It’s worth looking at all the options carefully, as many have a much more detailed explanation of how the particular bank calculates and applies interest. Take a look – it will be time well invested.