Compound Interest Calculator
September 7th, 2006 | by jg3 |Let’s say you have a savings account and while you’ve always known that you need to save that money for a rainy day, you look at it just sitting there and you’re not sure if you should do something else with it. Remeber that it is a savings account and not an investment account and you have little to no tolerance for risk. So, along comes an offer for a CD which pays a higher intrest rate, but ties up your money for a set length of time (or you’re hit with a penalty). “What,” you wonder to yourself, “should I do?”
That brings us to the Compound Interest Calculator. Here we can observe the differences between these options. Let’s pick an easy, round number to start with ($10,000.oo) and see what happens to it annually. We could pick a longer or shorter term, but 12-months is a good place to start.
If you put $10,000.oo in a savings account and the intrest rate is 4.40%* compounded monthly, at the end of one year you wind up with $10,448.98.
If you instead lock that same money up in a 12-month CD that earns at 5.20%* compounded annually at the end of one year you have $10,520.oo.
The difference, $71.02 is what you could call liquidity cost or the price you pay for having your money readily available. Incidentally, $71.02 is about 0.o71% of $10,000.oo which is almost exactly the difference between 4.4 and 5.2. The fact that one is compounded monthly accounts for the slight difference.
But that’s just what happens after one year. Now, let’s consider the effects of the increased intrest versus an early withdrawl penalty later on.
If you avoid rainy days for a period of two years the $10,918.12 you have in the savings account is growing and available to you at any time without penalty. For the CD, after the second year’s intrest is paid out you would have $11,067.04. The early withdrawal penalty (for a CD with a term that is 12 months or less) is three (3) months of interest regardless of when, prior to maturity, you make a withdrawal. And because it is paid out annually, you don’t get any intrest for that year, either.
During the second year that penalty would be $143.87 but when you add the $575.49 you miss out on by not getting your intrest paid out at the end of the 12-month term, your total loss is $719.36. Considering this, in a worst-case scenario where you have to pull your money out just before the term is up, you wind up around $485.16 less than you would have been had you just kept the money in the lower intrest savings account. You risk just under 1% of your stash plus the intrest for the whole year by betting that you won’t need access to the money before the CD matures. If you win, the higher intrest rate of the CD is excellent and after a few years of compounding annually your money is substantially more than if left in the savings account. For an interesting view of this difference, use a compounding calculator.
All of this is pretty basic, I know. It is simplified for my simple mind. And the take away isn’t earth shattering, but it is this: If you are going to need to access the money don’t put it in a CD. This just explains why. I’m fascinated by it because I really suck at math but I love the wonderful things that can be done with it.
Bonus: A shortcut to determining the quality of an investemnt is the Rule 72
* These numbers happen to be ING Direct’s rates today.
Filed under: money, Real Life
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