Investors should seek to earn returns on cash that they do not need immediately.
The return earned on excess cash comes from the time value of money, driven by the demand for capital itself.
Compounding of earnings causes your money to grow faster as time goes on; the longer you allow your money to compound, the larger the benefit.
Have you ever wondered why banks pay an interest rate? Perhaps the most obvious answer is to entice you to keep your money with them. But, how are they able to pay an interest rate in the first place? And why do they want to hold your cash? The answer is the time value of money, or the fact that money you have today is more valuable than the same amount in the future because of its potential earning capacity.
It may sound simple, but money that you have onhand today is valuable because you can do things with it. Of course, you could use it to buy something. But if you don’t need it immediately, you could also loan it out to someone, particularly to someone who wants to do something productive with it, and earn a return on it.
Funding The Next Great Idea
Imagine your friend is running a small business, say a coffee shop. Things are going well, and she wants to open another location. To do that she needs store space, new coffee-making equipment, and perhaps advertisements to announce the new location. This will be a big cash outlay. Cash that she doesn’t have onhand.
You happen to have extra cash and agree that her plan to expand is a good idea, so you loan her money to grow the business, keeping in mind that all investing involves some financial risk. In this case, she agrees to pay you back the original loan in three years plus some interest. Now she has the funding she needs to grow and you have converted your unused cash into something that can generate more money for you.
The demand for money, sometimes called capital, is exactly why money has time value. You can use cash that you have onhand to fund many productive activities — like a friend’s coffee shop (a personal loan), a large established company (corporate bonds), or even theU.S. government (U.S. Treasury bills). The revenue generated from these activities can allow you to earn a return on your capital invested. Ultimately, it’s important to determine the level of risk you are comfortable with by weighing the potential consequences and returns.
How Banks Pay Interest
Now, let’s go back to the interest that you earn at the bank. Banks are able to pay you this interest because they are taking a portion of your money and loaning it out. In turn, they earn interest and pass a portion– sometimes an exceedingly small portion– along to you.
Whether it’s you or your bank doing the lending, the dynamics are always the same: money is given to those in need of capital, and those people (or companies or governments) in need of capital, in turn, compensate the lender.
It’s the need for money itself that gives money time-value. In other words, the sooner you have money the more valuable it is because you can start earning more money on it.
What’s the right amount of interest?
Now that we understand the underlying mechanics of why and how interest is earned on money, we might find ourselves asking, “Ok, but who decides what the interest rate is anyway?”
At the most fundamental level, interest rates are set by the demand for capital compared to the supply of people willing to lend it. A good starting point for evaluating interest payments is to consider the amount you would get paid by someone who will almost certainly pay you back, for example, the U.S. government.
In fact, the U.S. government holds auctions every week asking for loans– U.S. Treasury actions. Yields for U.S. treasury debt are set during these auctions. These rates can serve as a good benchmark for other interest rates that you might see, like a certificate of deposit (CD) at a bank for example.
Don’t settle for average.
Knowing that yields on U.S. government debt are a good starting point for comparing interest rates, we can look at a couple of practical examples.
If you are considering a one-year CD from a bank, you would want to compare its interest rate to the latest yield from one-year U.S. Treasury bills. At the beginning of February, the national average yield on a one-year CD was 0.64%, compared to 2.56% for Treasuries of the same maturity. This means that the average rate on a CD is not very good. As a smart investor, you know to use Treasury yields as a baseline to compare other interest rates and not to settle for yields that are substantially worse.
If you were to compare your savings account rate, you would want to use the federal funds rate as a benchmark. This is the rate at which banks lend money to each other overnight. At the beginning of February, the effective federal funds rate was 2.4%. Compare that to the national average interest rate on a savings account of 0.09%. Again, as a smart investor, you know to compare your savings account rate to the federal funds rate and not settle for a meaningfully lower rate.
Compounding, or Why Rates (And Time) Are Important
A key reason to pay attention to the interest rate you are receiving is the effect that compounding can have over time. Compounding happens when you earn interest not only on your original investment, but also on all the previous interest payments that you have received. It might not sounds like much, but over time compounding winds up having a meaningful impact on our wealth.
To illustrate, let’s start with a simple example. Imagine you start with a penny, and every day it doubles in value for a month. So, on the second day you have 2 cents, on the third day you have 4 cents, then 8 cents, and so on. But before reading any further, how much would you expect to have at the end of those 30 days– perhaps $100, $10,000, maybe even $100,000?
Starting with 1 cent and doubling it every day would leave you with over five million dollars after 30 days! Take a look at the table below to see how your initial penny grew.
Magic Penny: Growth of 1 cent over 30 days
As you can see from above, the balance does not even break $100 until halfway through the month, and doesn’t reach $1mm until the third to last day. This extreme example illustrates the power of compounding over time. Returns start off slowly, but increase more and more as time goes on.
Compounding in the real world.
Of course, you would be hard pressed to find any investment that doubles every year, let alone every day. However, the impact on compounding is still profound.
Below, you can see the growth of $10,000 over 30 years at a 5% annual interest rate. You’ll notice in the first few years the account grows at nearly a constant rate. However, after about five years you start to see the power of compounding kick in. In fact, by the final year you would earn over $2,000 from your original $10,000 investment and have an ending balance of over $43,000, compared to $25,000 if you earned the same interest rate with no compounding.
Growth of $10,000 with 5% interest rate
This figure represents the growth of a $10,000 investment with a 5% annual interest rate over the course of 30 years, based on whether compounding did or did not occur. Please note, the calculations assume a hypothetical annual interest rate of 5%. The hypothetical yield on this investment is not based on, and should not be interpreted to reflect, any Betterment portfolio, or any other investment or portfolio, and is purely an arbitrary number. Further, the results are solely based on the calculations mentioned in the preceding sentences. These figures do not take into account any dividend reinvestment, taxes, market changes, or any fees charged. The illustration does not reflect the chance for loss or gain, and actual investment returns can vary from those above.
The time value of money is a fundamental concept for investing. As an investor, you should expect to earn money on your excess cash. You should also ensure that the amount you are earning is appropriate by comparing it to relevant benchmarks. Earnings from interest are particularly powerful as they compound over time. Compound growth affects all investments and is especially pronounced in retirement investments because of the long investment horizon. Investing early allows more time for your money to grow on itself.
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