Take Advantage of Compound Interest

Compound Interest helps you build wealth faster. Interest is paid on previously earned interest as well as on the original deposit or investment. For example, $5,000 deposited in a bank at 6 percent interest for a year earns $308 if the interest is compounded monthly. In just 5 years, the $5,000 will grow to $6,744.

Let's see how interest compounds on Lynne's savings. Assume that Lynne saves $125 a month for 30 years and the interest on her savings is compounded monthly.

This chart shows how compound interest at various rates would increase Lynne's savings compared with simply putting the money in a shoebox. This is compound interest that you earn. And as you can see from Lynne's investment, compounding has a greater effect after the investment and interest have increased over a longer period.

There is a flip side to compound interest. That is compound interest you are charged. This compound interest is charged for purchases on your credit card. Chapter 4, "Take Control of Debt," discusses this type of interest.

 Understand the Risk/
     Expected Return Relationship

When you are saving and investing, the amount of expected return is based on the amount of risk you take with your money. Generally, the higher the risk of losing money, the higher the expected return. For less risk, an investor will expect a smaller return.

For example, a savings account at a financial institution is fully insured by the Federal Deposit Insurance Corp. (FDIC) up to $100,000. The return—or interest paid on your savings—will generally be less than the expected return on other types of investments.

On the other hand, an investment in a stock or bond is not insured. The money you invest may be lost or the value reduced if the investment doesn't perform as expected.

How much risk do you want to take? Here are some things to think about when determining the amount of risk that best suits you.

• Financial Goals. How much money do you want to accumulate over a certain period of time? Your investment decisions should reflect your wealth-creation goals.
  

• Time Horizon. How long can you leave your money invested? If you will need your money in one year, you may want to take less risk than you would if you won't need your money for 20 years.
  

• Financial Risk Tolerance. Are you in a financial position to invest in riskier alternatives? You should take less risk if you cannot afford to lose your investment or have its value fall.
  

• Inflation risk. This reflects savings' and investments' sensitivity to the inflation rate. For example, while some investments such as a savings account have no risk of default, there is the risk that inflation will rise above the interest rate on the account. If the account earns 5 percent interest, inflation must remain lower than 5 percent a year for you to realize a profit.

Source: Department of Labor (www.dol.gov)

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