How Compound Interest Boosts Savings

Last Updated Dec 10, 2010 3:49 PM EST

Part two in a series with videos that teach older kids about money:

Compound returns are at the core of successful long-term financial planning. The longer you save, the more time your money has to grow. Likewise, the longer you take to pay off a debt the more interest you'll owe. Understanding how fast assets and debt grow is one of five core competencies needed to reach financial security, according to researchers at the Financial Literacy Center.

You can talk to your young teens and nearly adult kids about compound returns until you are blue in the face. Some telling statistics will help. But for a simpler, proven approach you can show them this video:

Or invite them to read this narrative:

Dave and Michelle met in college, five years ago. Theirs isn't a romantic story of love at first sight; instead they slowly built the foundation for a strong relationship. Dave asked Michelle out for a coffee, then another, and another. Their relationship continued to grow stronger, and they recently got married.
When they got $5,000 in cash as wedding presents, Michelle and Dave had to decide what to do with the money. The answer didn't seem obvious. Looking over their finances didn't take long because they didn't have much money, especially since Michelle's job at the time paid more like an internship. The two of them don't generally consider themselves big planners and, at first, it seemed pointless to even think about investing for the long term. Dave suggested not investing right away, but instead waiting until they had better jobs and made more money.
But Michelle told Dave about the 7 and 10 rule. The rule describes how long it takes for an investment to double. At a 7% rate of return, it takes about 10 years for an investment to grow twice as large. At a 10% rate of return, it takes only about 7 years to double your money.
At first, Dave wondered whether they could get such a high return: 10% is a lot. Michelle pointed out that a 7% return might be more realistic. After all, they would be investing for the long term. Dave realized that over the long term a diversified portfolio of stocks yields returns in that range.
The simple 7 and 10 rule helped Michelle figure out that even at a 7% rate of return, the original $5,000 would grow to a whopping $160,000 by the time she and Dave turn 75. When Michelle first pointed this out to Dave, he thought something had to be wrong with Michelle's calculation. But, as Michelle explained to him, the money grows that much because the returns compound over time. In other words, all of the money, including the earned interest, gets reinvested every year so that over the long term, there's some serious build-up.
If Dave and Michelle earn a 7% rate of return, their investment would double every 10 years. If they invest $5,000 when they are 25 years old, then: by age 35, it would double to around $10,000, which would double again by age 45 to around $20,000 which would double again by age 55 to around $40,000 which would double again by age 65 to around $80,000 which would double again by age 75 to around $160,000.
If Michelle and Dave waited until they were 55 years old to invest the $5,000 and earned the same 7% rate of return, they would end up with $20,000 by the time they were 75. And while $20,000 would be nice, the $160,000 they'd have if they invested right away would be even nicer.
Michelle also showed Dave the other half of the 7 and 10 rule. If their investments perform really well, their money could grow even faster. At a 10% rate of return, their investment would double in only 7 years. By the time Dave and Michelle reached their mid-70s, their $5,000 would double a whole bunch of times and turn into $640,000.
Dave and Michelle decided to invest their $5,000 right away, giving it more time to grow. When their friends and family gave them $5,000, they never imagined it could turn into six figures. But by applying the 7 and 10 rule, Dave and Michelle realized the money could turn into $160,000 or maybe even $640,000. Investing the money was the best wedding gift they could have given themselves.
Research shows that these simple devices -- a video or narrative (both prepared by the Financial Literacy Center) -- will have a lasting impact on the financial knowledge and behavior of young adults who view or read them.

Photo courtesy Flickr user rmgimages
More video and narratives to share with kids on MoneyWatch:

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  • Dan Kadlec

    Daniel J. Kadlec is an author and journalist whose work appears regularly in Time and Money magazines. He is the former editor of Time’s Generations section, which was written and edited for boomers. Kadlec came to Time from USA Today, where he was the creator and author of the daily column Street Talk, which anchored the newspaper's business coverage. He has co-written three books, including, most recently, With Purpose: Going from Success to Significance in Work and Life. He has won a New York Press Club award and a National Headliner Award for columns on the economy and investing.