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“Time is money” is a familiar expression. When it comes to saving, a plan where you start with less money early will often have greater ultimate value than saving larger sums later. The additional time matters because of compounded interest, a concept that is known as the time value of money. One of the best financial habits you can form is to start saving as early as possible, even with small amounts.
Many savings accounts offer interest on the money held in them. The three main terms to know are principle, interest rate, and time period. The principle is the amount of money you start with, the interest rate is the percentage of the principle to be paid, and the time period is how often the interest is paid, the most common being annually. For example, if an account pays 5% interest annually, on a $100 balance you will earn $5 at the end of the year.
Compounded interest is when the interest you earn in a time period is added to the account balance, allowing interest to be earned on the interest. This is an important component of how savings grows in value, no matter the interest rate or time frame. As a hypothetical example, at age 10 you deposit $100 savings in an account that pays 10% annually. (Note: interest rates are currently lower than this so 10% is used only for mathematical ease, but the concept holds true no matter the interest rate.)
- At the end of the first year you would have $110, which is the $100 starting balance plus the $10 interest.
- Interest the second year would be calculated on that $110, and 10% is $11, for a total of $121.
- The third year the interest earned is $12.10 and your balance grows to $133.10.
- Ten years later, at age 20, without contributing any additional money you would have $259.37.
How does that compare to starting later?
- If you waited until 17 to start saving, even if you deposited $150, at 20 years old you would have $199.65.
The difference is even more dramatic if you save each month after that initial deposit. Again, at 10% interest rate:
- Starting at age 10 with $100 and contributing $5 per month, at 20 the total amount you deposited would be $700. The total balance would be $1215.62 thanks to compounded interest.
- Waiting until age 17 with $150 and adding $10 per month, at 20 you would have contributed $510, but have a total balance of $596.85. Even if you contributed $20 per month, which is a total savings of $870, you would have a total of $994.05.
Online calculators can let you play with different dollar amounts, interest rates and time frames to see how your money can grow. One option is this compound interest calculator.
Thinking in terms of 10 years may seem irrelevant to you now, but understanding how the time value of money works is important for your short- and long-term savings plans.