ben is comparing savings accounts at different banks and finds that most are offering an interest rate of about 1%. how does this low interest rate impact the power of compounding?

1 month ago 27
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A low interest rate, such as about 1%, significantly diminishes the power of compounding in savings accounts. Here’s how it impacts compounding:

  • Slower Growth of Savings : With a low rate, the interest earned each period is small, so the overall growth of the savings balance is much slower. Compounding means earning interest on both the principal and accumulated interest, but when the rate is low, the incremental gains from compounding are minimal
  • Longer Time to See Meaningful Gains : At 1%, it takes a very long time for savings to grow substantially. For example, using the Rule of 72, it would take roughly 72 years for the savings to double at a 1% interest rate, which is far slower than at higher rates
  • Reduced Real Returns Due to Inflation : If inflation exceeds the interest rate, the real purchasing power of the savings actually declines over time. This means even though the nominal balance grows slightly, the money’s value in terms of buying goods and services decreases, further weakening the benefit of compounding
  • Lower Incentive to Save : Because the returns are low, savers may feel less motivated to put money into savings accounts, potentially missing out on the benefits of compounding altogether

In summary, while compounding still functions at low interest rates, its effect is much weaker, requiring a longer time horizon to accumulate meaningful wealth. Savers like Ben might consider looking for accounts with higher rates or alternative investments to better harness the power of compounding