CDs and the Money Making Magic of Compound Interest
by Deborah O'Malley, M.Sc. and Melvin Pasternak, Ph.D
Albert Einstein called compounding "the greatest mathematical discovery of all time."
For those regularly carrying hefty debt on their monthly credit card bill, Einstein's law of financial physics is not good news. But for an investor, the principles of compound interest can be used to make a substantial amount of money over time.
To tap into the money-making magic of compound interest, it's crucial to first understand what compound interest is and how it works.
Financially speaking, compounding is the exponential increase of an investment. But in simpler terms, compounding is interest you earn on interest.
For example, let's say you put $10,000 in a certificate of deposit at your bank or credit union. If the CD pays 5% interest annually (yes, some paid that much in 2008 and 2001), the bank will give you about $500 in interest for the first year of your investment.
If you leave that $500 in your account, it will start earning interest, too. That means in the second year, your $10,500 principal balance would earn $525 in interest.
Over time, this phenomenon turns into the powerful magic of compound interest. Continuing with the example above, your $10,000 initial investment would double to $20,000 in just 14 years if you continue to let it collect interest and compound.
If that money remained untouched, it would earn twice as much interest between years 15 through 28. In year 29, you'd effectively be earning 20% interest on the original investment (sometimes called "yield on cost"), all without needing to lift a finger. By year 30 your total investment would grow to a whopping $43,219 -- and remember, the original investment was just $10,000 in this example.
If the original investment was $100,000 you'd be looking at $432,190 in interest over that time!
That's the money making magic of compounding.
Two Key Tips to Maximize Compounding Interest
1. The earlier you start, the better compounding works. For example, if you're 33 years old, a small $100-per-month (or $1,200 annual) contribution at a 1.5% annual interest rate will turn into nearly $60,000 by the time you reach 70. By contrast, if you start at age 66, this same investment amounts to just $5,000. (It works with stocks too -- see how One Normal Lady Turned $200 into $7 Million by buying stock shares and letting them compound). Overall, the longer you can let your investment sit and earn interest, the faster and larger it will ultimately grow.
2. The more frequently interest is paid, the more quickly wealth will build. For example, by investing in a CD that pays interest quarterly, your money will compound more times and grow faster than if you were to invest in a CD that pays and compounds interest semiannually or annually. Therefore, to more quickly obtain wealth, always chose the shortest compounding period you can.
How to Use Certificates of Deposit (CDs) to Build Your Wealth
CDs are secure and federally-insured investment vehicles that offer a fixed interest rate until a specific maturity date. The advantage of a CD over a high-interest savings account is it offers a guaranteed interest rate that will remain unchanged for the term of your investment. The catch is your money is not liquid. You must keep it locked up for the specified time period. Early withdrawal often results in a penalty. The interest gain is generally taxable.
Remember, no matter what shape your finances are in right now, you can jumpstart your financial future by taking advantage of compounding today. CDs offered through a bank or credit union have their own terms, advantages and disadvantages, so be sure to read up on the 5 Things to Know Before Opening a CD so you can shop smart and effectively start building your wealth right now.