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How Savings Works

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.

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.

Let's look again at that $100 in an account earning 6% interest. The $106 you have after the first year would earn 6% again the next year -- $6.36, or a 36 cent increase. After you add that to the total, you would have $112.36. And that new total will then earn 6% the following year -- $6.74, another increase.

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.

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