When it comes to the subject of wealth growth, it is clear that compound interest plays a decisive role. Compound interest is the foundation of all investment concepts.
After all, compound interest is interest earned on top of interest already earned. This is essentially the easiest way to grow your pot of money, if you have the time on your side, that is.
How Compound Interest Works
As the name suggests, compound interest works by building up and increasing your capital over time. The interest you earn on your principal is added to your principal. Combined, they will earn you even more interest.
The process of compounding continues and you make your money grow faster than if you were relying on simple interest.
To put it in perspective, consider a $ 1,000 investment that pays 4% per annum compounded.
|Year||Amount at the beginning of the year||Interest earned in the year||Amount at the end of the year (including interest earned)|
|1||$ 1,000||4 percent x $ 1,000 = $ 40||$ 1,000 + $ 40 = $ 1,040|
|2||$ 1,040||4% x $ 1,040 = $ 41.60||$ 1,040 + $ 41.60 = $ 1,081.60|
|3||$ 1,081.60||4% x $ 1,081.60 = $ 43.26||$ 1,081.60 + $ 43.26 = $ 1,124.86|
|4||$ 1,124.86||4 percent x $ 1,124.86 = $ 44.99||$ 1,124.86 + $ 44.99 = $ 1,169.85|
As you can see in the table above, the interest earned increases every year due to the increasing base amount.
This is, my friends, why it is always a good idea to start investing as early as possible: your investments have a good chance of accumulating over a longer period of time.
Time is really of the essence for compound interest to work its magic as brilliantly as possible. Whether we like it or not, in this context, time is money.
How to use compound interest to multiply your money
The smartest way to use compound interest to your advantage is to simply start saving and investing early so your money has more time to grow. Another crucial part of the equation? You will have to stay invested.
Here’s an example that will hopefully motivate you to get started right away, if you haven’t already.
Suppose all parties – Amy, Betty, Cali, and Dan – start with an initial investment of $ 3,000 and invest $ 300 per month consistently until the age of 62. Think of $ 300 as setting aside $ 10 a day if that helps!
Suppose the estimated annual interest rate is 5%, compounded annually. The only factor we vary is the age Amy, Betty, Cali, and Dan start to invest. This is important because it directly affects the number of years they save and invest their money.
|Age at which they start to invest||25||29||30||35|
|Number of years they invest||37||33||32||27|
|Amount they would have saved at age 62 *||$ 384,105||$ 303,239||$ 285,370||$ 208,009|
* Rounded to the nearest dollar
The numbers above should send a clear message: the earlier you save and invest, the better your returns will be over the long term. Even a year of procrastination makes a pretty big difference – look at the difference in the amount Betty and Cali would have saved (that’s $ 17,869)!
For those who don’t bother typing in the calculator, Amy would have saved 1.84 times Dan’s in the end, the only difference being that she started 10 years earlier.
Don’t worry if you don’t know where to start. Plunging your toes into the vast world of investing is certainly intimidating, but know that we all have to start somewhere. To get started, take the time to read these investment tips and investment strategies that are suitable for beginners.
Currently, there are many types of investment instruments (e.g. ETF, stocks, bonds) as well as ways to invest (e.g. DIY investing, robotic advisers, regular savings plans , fixed investment). Do your research and do your own due diligence before spending your hard earned money.
Compound interest is a double-edged sword
Just as it’s possible to build a small fortune through the magic of compound interest when you save or stay invested for a long time, compound interest can work against you quickly as well. In fact, much faster than if you were trying to make your money grow.
Be very careful when it comes to things like credit card debt and loans. The often high interest rates of around 26 percent and the compound nature mean that your debt can snowball and get out of hand if you aren’t able to manage your debt properly.
ALSO READ: 4 Investment Tips Every Newbie Should Know
If you are currently in debt, do your best to pay off your debt. Consider a balance transfer to minimize your interest payments while remaining committed to paying off your credit card debt within 6 to 12 months. Do you have more than 12 times your monthly salary in debt?
Consider a debt consolidation plan instead. This government approved program is available from all major banks in Singapore. And if you have to, definitely consider seeking additional credit help. There is no shame in doing this, really.