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IV. Growing Your Money True money masters use their money to make more money. Whether you’re saving for an emergency fund or investing, you should understand a couple of concepts about how to make money grow. Simple Interest. Assume you invest $100 in a savings account that pays a yearly interest rate of 1 percent. Multiplying the principal of $100 by the interest rate of 1% gives you an interest payment of $1. The next year and each year thereafter, you will be paid $1 of interest. If you want to know how much you’d have in 30 years, you’d just multiply $1 by 30. After 30 years you would have $130. Simple interest is paid out as it’s earned and does not become part of the principal balance. Reflect on Learning: Can you write a simple interest equation for this? $100 (principal amount) x .01 (rate of interest x 30 (time period) = $30 the principal balance , so now you have $101 in principal. You then start earning interest on that amount. Year after year, the interest is tacked on to the principal. In this example, you would have $134.78 after 30 years. Reflect on Learning: The difference between what simple and compound interest earn may not seem like much money because we are using just $1 and 1% in the example. But assume you had an account with $25,000 in it. With a simple interest rate of 5% you’d have $43,750.00 after 10 years; With compounding interest you’d have $51,973.20. Go to the selected compounding calculator and practice compounding. Observe how earnings grow at different rates by changing the amount invested, the interest rate, and number of years invested. The Universal Power of Compounding. Here’s an important Fin Lit Trivia Fin Lit Trivia Fin Lit PRODUCT PREVIEW Compound Quote My wealth has come from a combination of living in America, some lucky genes, and compound interest. – Warren Buffett, Rich Guy Fin Lit Trivia Fin Lit Trivia Fin Lit Trivia Compound Interest. Compound interest is very different. It’s a saver’s best friend because it helps savings grow at a much faster rate than simple interest. Compounding means that the interest earned is added to the principal balance and included in the calculation of interest in the next compounding period. Compounding increases the principal balance which, in turn, increases the amount of interest earned. Compound interest has a money snowball effect. Compare compound interest with the simple interest example above: Assume you invest $100 in a savings account earning interest at a yearly rate of 1%. After one year you would have earned $1. With compound interest, the $1 you earned gets added to
financial literacy concept: the principle of compounding applies to investments too. For example, many stocks pay a dividend, which is a portion of the company’s profit that is distributed to the shareholders quarterly or yearly. Experienced investors do not cash out these dividends. Instead, they use them to buy more shares of stock. On and on, as they reinvest the dividends, they acquire more and more shares, which earns them more in dividends. Compounding is a powerful wealth building tool to supersize savings and investments .
Einstein on Interest Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it. – Albert Einstein, Smart Guy
THE 21st CENTURY STUDENT’S GUIDE TO FINANCIAL LITERACY 139
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