When it comes to the topic of wealth growth, there is no denying that compound interest plays a huge role. Compound interest is the foundation of all investment concepts.
After all, compound interest is interest earned on top of interest already earned. It’s basically the easiest way to grow your kitty, if you have time on your side, that is.
How Compound Interest Works
As the name suggests, compound interest works by compounding and increasing your principal amount over time. The interest you earn on your principal amount is added to your principal amount. Combined, they will earn you even more interest.
The compounding process continues and you grow your money faster than if you relied on simple interest.
To put things into perspective, consider a $1,000 investment that earns 4% compounded annually.
|Year||Amount at the beginning of the year||Interest earned during the year||Amount at the end of the year (including interest earned)|
|1||$1,000||4% 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% x $1,124.86 = $44.99||$1,124.86 + $44.99 = $1,169.85|
As you can see from the table above, the interest earned increases each year thanks to the growing base amount.
That’s why, my friends, it’s 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 indeed money.
How to Use Compound Interest to Multiply Your Money
The wisest 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 need to stay invested.
Here’s an example that will hopefully motivate you to get started right away, if you haven’t already.
Let’s assume that all parties – Amy, Betty, Cali and Dan – start with an initial investment of $3,000 and invest $300 per month steadily until age 62. Think of $300 as setting aside $10 a day if that helps!
Assume the estimated annual interest rate is 5%, compounded annually. The only factor we vary is the age at which Amy, Betty, Cali and Dan start investing. This is important because it directly affects the number of years they save and invest their money.
|Age when they start investing||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 figures above should send a clear message: the sooner you save and invest, the better your returns will be over a long period of time. Even a year of procrastination makes a pretty significant difference – look at the difference in how much Betty and Cali would have saved (that’s $17,869)!
For those who can’t bother typing into the calculator, Amy would have saved 1.84 times that of Dan when all is said and done, the only difference being that she started 10 years earlier.
Don’t worry if you don’t know where to start. Dipping your toes into the vast world of investing is certainly daunting, but know that we all have to start somewhere. To get started, take the time to read these beginner-friendly investment tips and strategies.
As it stands, there are many types of investment instruments (eg ETFs, stocks, bonds) as well as ways to invest (eg DIY investing, robo-advisors, investment plans). regular savings, fixed investment). Do your research and do your own due diligence before spending your hard-earned money.
Compound interest is a double-edged sword
Similar to how it’s possible to build a small fortune with the magic of compound interest when you save or stay invested for a long time, compound interest can also quickly backfire. In fact, much faster than if you were trying to grow your money.
Be very careful when it comes to things like credit card debt and loans. The often high interest rates of around 26% and the capital intensive nature mean that your debt can snowball out of control if you are unable to manage your debt properly.
ALSO READ: 4 investment tips every beginner 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 committing to paying off your credit card debt within 6-12 months. Do you have an amount of debt greater than 12 times your monthly salary?
Consider a debt consolidation plan instead. This government-approved program is available from all major banks in Singapore. And if you must, definitely consider consulting a credit counselor for additional help. There’s no shame in doing that, really.