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101: Compounding and Planning
Companies Served Since 1981

101: Compounding and Planning


By Gregg Schoenberg Tuesday, November 22, 2011

Back in our inaugural HBS post about Interest Rates, we had a look at the way interest rates are set by the Federal Reserve and the effects that rates have on entrepreneurs who need to borrow money to launch or support their businesses.  Now we want to take a look at how rates affect those who are saving to start a new business or to expand an existing one.  In particular, we are going to focus on a very basic yet powerful concept that is available to all entrepreneurs as they attempt to save for the future: compound interest.

Compound interest is simply defined as interest paid on both principal and accrued interest. A quick example can help illustrate what this means to a saver in the real world.  Say you put $10,000 into a bank account earning 5% a year.  At the end of the first year you will have $10,500, as your initial $10,000 deposit grew by $500.  Quick question: at the end of year two, how much money will you have in your account?  If you answered $11,000 (or an additional $500), you are overlooking the magic of compound interest.

Because you will continue to earn interest on your initial deposit of $10,000, as well as on the additional $500 that you earned in year one, your balance at the end of year two will be $11,025. While an extra $25 might not have you worshiping at the altar of compound interest just yet, a look at its effects over the longer term may just make a believer out of you.

Suppose you run a business that regularly requires you to purchase some fairly expensive equipment that has a limited useful life expectancy.  For example, let’s assume that you know you will need to purchase a new $50,000 delivery truck every 10 years. How soon should you start planning, and saving, for this or any other large purchases that your business needs to remain vital? The short answer is: right now.

If you take our advice, you will have to set aside $320 a month in order to be able to purchase that truck when the old one is ready for the junkyard.  If you are like a lot of people though, you probably don’t think too much about purchases that are 10 years off. Maybe you decide to start saving 5 years from now and think that will do the trick.  Well, it might, but you’ll have to set aside $730 a month rather than $320.  Put another way, if you get started right away you’ll need to save a total of $38,400 vs. $43,800 if you wait 5 years. And that means you’ll have $5,400 to put towards other uses, like giving yourself a bonus for being such an astute financial manager.

While this is just one example, the math always reveals the same result: the sooner you start saving, the less you need to set aside each month, no matter the size or the date of your future purchase.  So in order to avoid the financial pain associated with large but necessary purchases, it always pays to start saving as soon as possible for big dollar purchases you’re expecting down the road.

 

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