Have time on your side? Hone in on compound interest. Learn how compound interest works and why you should ride on it to grow your wealth.
When it comes to the topic on growing wealth, there’s no escaping the fact that compound interest plays an instrumental role. Compound interest is the foundation of all investing concepts. After all, compound interest is interest earned on top of interest already earned. It is essentially the easiest way to grow your pot of money, if you have time on your side, that is.
How compound interest works
As its name may suggest, compound interest works by compounding and growing your principal amount over time. The interest that 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 quicker than if you were to rely on simple interest.
Just to put things into perspective, consider a $1,000 investment that earns 4% annually compounded.
|Year||Amount at the start of the year||Interest earned in 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 yearly thanks to the growing base amount.
This, my friends, is why it’s always a good idea to start investing as early as one possibly can: your investments get a fair shot at compounding over a longer time period.
Time is really of the essence for compound interest to work its magic as brilliantly as it can. 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 simply to start saving and investing early so your money has more time to grow. Another crucial part of the equation? You’ll have to stay invested.
Here’s an example that will hopefully motivate you to start right away, if you haven’t already done so.
Assume that all parties —Amy, Betty, Cali, and Dan — start with an initial investment of $3,000 and they invest $300 monthly consistently till they are 62-years-old. Think of $300 as putting aside $10 a day if it helps!
Assume the estimated annual interest rate is 5%, compounded annually. The only factor we’re varying is the age Amy, Betty, Cali, and Dan starts investing. This is important because it directly affects the number of years they save and invest their money.
|Age at which they start investing||25||29||30||35|
|No. of years they invest for||37||33||32||27|
|Amount they would have saved at 62-years-old*||$384,105||$303,239||$285,370||$208,009|
* Rounded to nearest dollar
The figures above should send a crystal clear message across: the earlier you save and invest, the better your returns will be over a long period of time. Even a year of procrastination makes a fairly significant difference — look at the difference in amount Betty and Cali would have saved (it’s $17,869)!
For those who can’t be bothered to punch in the calculator, Amy would have saved 1.84 times that of Dan’s when all is said and done, the only difference being she started 10 years earlier.
Fret not if you don’t know where to begin. Dipping your toes into the vast world of investing sure is intimidating, but know that all of us have to start somewhere. For a start, spend some time reading about these beginner-friendly investing tips and investment strategies.
As it stands, there are many different types of investment instruments (e.g. ETFs, stocks, bonds) as well as ways that you can get invested (e.g. DIY investing, robo advisors, regular savings plans, lump sum investing). Research and do your own due diligence before plonking your hard earned money down.
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 long, compound interest can also work against you quickly. In fact, much quicker than if you were trying to grow your money.
Be extra careful when it comes to things like credit card debt and loans. The often high interest rates of about 26% and compounding nature mean your debt can snowball and spiral out of control if you aren’t able to manage your debt properly.
If you are currently dealing with debt, do your best to pay down your debt. Consider a balance transfer to minimise your interest payments while you stay committed to clearing your credit card debt within 6 to 12 months.
Have a debt amount that’s over 12 times your monthly salary? Consider a debt consolidation plan instead. This government-approved scheme is available with all the leading banks in Singapore. And if you must, definitely consider seeking credit counselling for extra help. There’s no shame in doing that, really.
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