What is compounding interest and how can it help you?

Through Memphis Housing Authority’s Family Self-Sufficiency program, we support residents in our public housing programs to create pathways toward financial security and homeownership. One of the most important ways to get there is to establish a strong understanding of your budget and to make room for saving. Even small investments in your future can add up over time, especially when considering compounding interest. But what is compounding interest and why does it matter? We’ll break it down for you here. 

What is compounding interest?

When you put money into a savings-focused account, banks and other financial businesses give you an incentive to store your money with them. This is called interest. Every year you keep money with that organization, they’ll invest a percentage of your account balance into your account. How much they invest is based on the interest rate your bank or credit union offers. While they vary, the interest rate is usually less than 3%. 

Compounding interest is what happens when you commit to saving over time. As you put more money into savings and your banking partner adds interest payments to your account, the overall interest you earn increases. It creates a savings snowball effect that makes you more money over time. 

Can you provide me examples of compounding interest? 

Sometimes, it’s easier to see how compounding interest works to understand why it’s helpful. We’ll show you an example. Say you have a baby and want to save for them to go to college, buy a car or help them buy a house. Here are some ways that compounding interest would earn you money over the child’s lifetime:

• You initially invest $250 in a savings account that earns 1.5% annual interest. Every month, you put $50 in the account. If you do not touch the money and continue investing $50 monthly for 18 years, you’ll have $12,620 in the account. You will have contributed $11,050 of that money and earned $1,570 in interest. 
• If you invest the same $250 in a savings account that earns 2.5% and continue contributing $50 monthly, you’ll have $13,822 in the account after 18 years. The $11,050 contribution remains the same, but you’ve now earned $2,772 in interest. 
• Consider the same $250 initial investment and a 3.5% interest rate. After 18 years and $11,050 in investments, you’ll have $15,164 in the account with $4,114 in earned interest. 

With this example, you can see how consistent saving and having an account that earns compounding interest can make a massive difference in the value of your account over time. Any earned interest in your account is extra money you can put toward things you love – like your family, home or other expenses. 

Want to see how it could work for your scenario? Using this government-backed compounding interest calculator, you can calculate how much interest you could earn over time. 

Why should I try to make the most of compounding interest?

The main thing we want you to take away is that any interest you earn on an account is good interest. If you are saving money at your house or in a debit account, you are not earning any interest and could be at a higher risk for fraud, theft or spending the money you intended to save. A dedicated savings account can help change your mindset, even if you can only contribute $5 a month. 

You might think that earning a few dollars a year doesn’t mean much, but that money grows exponentially over time. This can make an enormous difference when you want to buy a house, pay off debt or make other big life decisions. While you might not be able to put much money into savings today, our goal at MHA is to provide housing opportunities that create a better financial situation for you. Every dollar you save is an investment in your future – and that’s an investment worth making.