Question: We talk about making money grow. Does anyone know what "making your money grow" means?

Explain: Money can grow because of the power of compounded interest. This simply means that you earn money on the interest you leave in your account.

Compound interest can be defined as interest earned on an investment at periodic intervals and added to the original amount of the investment. Future interest payments are then calculated and paid at the original rate but on the increased total of the investment. This is really interest paid on interest.

Interest can be compounded daily, monthly, quarterly or annually.

Explain: Let's work through this compound interest example.

$1,000 @ 3% interest compounded annually earns $30 of interest at the end of one year. At the end of 12 months, you would have $1,030.00.

Explain: If you reinvest the $1,030 at a 3% annual interest rate, you would earn $30.90 at the end of the second year, bringing your total investment to $1,060.90.

The extra $.90 is the interest you earned due to compounding interest.

Activity: Let's see if we can calculate the interest you would earn at the end of year three.

Instructor Note: Call on a volunteer to explain the calculation. Year 3 example will appear upon a second mouse click.

Explain: At the beginning of year three, you could again invest this money and earn $34.83 in interest at the end of 12 months.

Your total investment would then equal $1,095.73.

Explain: The extra interest due to compounding may not seem like much, but over the years the interest adds up. When you compare your investment of $1,000 over a 10-year period, you can see that without compounding interest, you would earn $300 in interest. However, with compounding interest, you earn an extra $43.90.

Activity: Let's calculate the difference in what you would earn if you received 7% interest on the same $1,000 investment after 2 years.

Instructor Note: Formula is provided on Slide #9 for participants to review.

Explain: Using the formula, you can determine that in the first year you will earn $70 in interest.

The second year of investing will yield $74.90.

Explain: This table shows that even small amounts of savings add up. Look what happens when you save just $1 a day and invest it at 5% interest with daily compounding interest.

At the end of year one, you would have a total of $365. Using the same calculations as explained earlier with the annual compounding interest example, you would earn an extra $9 at the end of your first year. This brings your total investment to $374.

The real power of compounding interest shows at the end of 30 years. If you did not invest your money, you would have a total of $10,950. By investing your money, you earn an extra $14,465, bringing your 30-year investment total to $25,415.

Explain: Of course, not all savings accounts are the same. Compare the Annual Percentage Yields (APY's) of the savings products, not the interest rates. The higher the APY, the more interest you will receive.

Lesson Summary:
Congratulations! You have completed How Your Money Can Grow in this money mangement series of classes.

We've covered information that has helped you to understand compound interest.