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How Savings Works

When setting up a savings plan, it's a good idea to think about more than just how much money you'll need in the future. You should also be looking at ways your money can earn more money for you.

Fortunately, this is a lot easier than it sounds. In fact, just about the only way you can keep from earning more money with your savings is to put it under your bed or in a safe. If you take your money to a bank you can guarantee that over time you'll make more money, and you won't have to do a bit of work for it.

That's because banks offer interest. In exchange for opening an account and giving the bank your money, the bank agrees to increase your money by a certain percentage every year.

For instance, if you were to take $100 and put it in an account that offers 6% interest, by the end of the year the bank will have given you six dollars. So, without doing anything, your savings has grown to $106.

Best of all, it's risk free. The federal government guarantees your deposits. Even if the bank goes bankrupt, you'll get your money back.

Start Saving Early

You've likely heard it said before, but it bears repeating: The earlier in life you can start saving and investing your money, the better.

Why? The power of compound interest. In the long run, compounding – which simply means that your investments make money, and then that new money in turn also earns a profit – offers a very powerful and easy way to make your money grow.

    Here's an example.

    Suzanne and Jack both save $1,000 per year ($83.33 per month or $19.23 per week). The money each saves earns 10% interest per year. Suzanne starts at age 22 and stops at age 30. Jack starts at age 30 and stops at age 65. On the face of it, you might think Jack will look better in the long run, having saved for a full 35 years (as compared to Suzanne's eight-year effort). But the reality of long-term savings isn't always what it appears.

    This Chart demonstrates the value of starting to save your money early.

In this example, Suzanne only invested a total of $8,000. But by age 65, she will enjoy net earnings of $380,865. Jack, on the other hand, will have put away a full $35,000 by his 65th birthday. But his net earnings will be $294,039 – $86,826 less than Suzanne's. Jack never caught up.

Simple interest calculation

With the simple interest calculation, interest is paid on the original amount of deposit, year after year. The formula is:

    Original Dollar Amount x Interest Rate x Length of Time (in years) = Amount Earned.

    If you had $100 in a savings account that paid 6% simple interest, you would earn $6 in interest over the first year.

    $100 x 0.06 x 1 = $6

At the end of two years, you would have earned $12. The account would continue to grow at a rate of $6 per year, despite the accumulated interest.

Compound Interest

At first, interest might not seem like a lot of money. But it grows over time. And it can add up very quickly – thanks to a powerful moneymaking tool known as compound interest.

Put simply, this is interest earned on interest. The formula is: (Original Dollar Amount + Earned Interest) x Interest Rate x Length of Time = Amount Earned.

    If you had $100 in a savings account that paid 6% interest compounded annually, the first year you would earn $6 in interest. The calculation the first year would look like this:

    Interest earned in one year: $100 x 0.06 x 1 = $6

    Account balance at end of year one: $100 + $6 = $106

    With compound interest, the second year you would earn $6.36 in interest. And, by the end of the second year, you would have earned $12.36 in total interest. The calculation the second year would look like this:

    Interest earned in year two: $106 x 0.06 x 1 = $6.36

    Account balance at end of year two: $106 + 6.36 = $112.36

As long as you leave the money in there, it will keep earning more. If you left that same $100 in a 6% interest account for 40 years, you'd have $1,028, and your annual interest earnings would be more than $50 per year.

The Rule of 72

One simple way to see the power of compound interest is through the "rule of 72." It's a formula for figuring out how quickly your money will double if left alone in an interest bearing account.

All you have to do is divide 72 by the interest rate. So if your rate is 6%, divide 72 by 6. At that rate, it will take 12 years to double your money.

Big Money

Still not impressed? Sure, 12 years is a long time to double your money. But that's only if you put your money in once and leave it. If you keep contributing, your money will really grow.

Consider that 6% account one more time. If you were to put in another $100 each year for 40 years, you'd wind up with $17,433 and you'd be earning more than $1,000 in interest.

It really pays to start saving early and regularly.

Read the Fine Print

Just as banks give, they can take away. If you're not careful, penalties and fees can cut into your interest. Sometimes they even eat into your actual savings. So it's important to read the fine print when you open an account so you can know where the potential pitfalls might lie.

Watch out for:

  • Fees, charges, and penalties. These are usually based on minimum balance requirements, but they can also be attached to transactions such as ATM withdrawals and online transfers.
  • Interest thresholds. Some accounts require minimum balances before they even begin paying interest.
  • Variable interest rates. Some accounts – most often money-market accounts – will pay different interest rates for different size balances, with higher balances earning higher rates.