The great Albert Einstein once said, “Compound interest is the 8thwonder of the world. He who understands it earns it, he who doesn’t pays it”. The man was an absolute genius and it’s hard to argue with him. If you haven’t heard about compound interest, then I’m telling you, it is actually one of the most powerful concepts in the world of investing.
The concept of compound interest is also least understood. That’s why in this post, I unpacked the basics of compound interest so you can understand its power and start using it for your financial freedom.
What is Compounding Interest?
When people think of interest, they often think of a loan or credit cards where they pay an interest expense from borrowing. But interest can also work in your favor when they are earned from the money you’ve saved and invested.
Now, there are two types of interest – simple interest and compound interest. From their naming convention, you may rather think that latter is complicated, when really, compound interest concept is also simple.
Simple interest is straightforward as it is “interest ONLY on the principal” or the money you saved. For example, if you have Php 100 and a simple interest of 10%, you’d earn Php 10 a year. Your interest earnings would never change because the principal stays the same. After 5 years, you will have Php 150.
On the other hand, compound interest is “interest on the principal” AND “interest on the interest earned”. There is exponential or rapid growth compared to consistent growth provided by simple interest. If you have Php 100 and a 10% compounded interest rate, suddenly the numbers change. At the end of year 1, you will still have Php 10. At the end of year 2, you earn interest on all Php 110, meaning, you’ll earn Php 11 (Php 100 x 10% = Php plus Php 10 x 10%= Php 1).
It might be a small difference, but in the long-run, it has an enormous impact on your money. After 5 years, your Php 100 savings has grown to Php 161 (principal plus interest) on its own. This is why the idea of compounding interest is like making your money work for you.
How to Harness the Power of Compounding Interest
Now you know, the way compound interests work is fascinating. It can surely make a huge difference in your savings and investments (stocks or bonds). But how do you harness its full potential?
There are three factors that play a part in growing your money: principal, interest rate and time. Does it sound like a math investment formula? You are totally right! To actually make the most of compounding interest, you just have to maximize each variable.
> SAVE AS MUCH AS YOU CAN. The more you add to your savings and investment, the more money you have to earn interest. And the more you put in, the faster it grows with compound interest.
> FIND SECURITIES THAT YIELD HIGH INTEREST. Sure, compound interest also works in bank savings accounts, but the rate provided by banks is a fixed 1% or even less. You can consider investing in mutual funds, or directly in bonds or stocks which provide higher potential annual returns. Due to the market volatility however, there are risks involved in investing.
Another option which I recommend is to put your money in a single-pay VUL (Variable Universal Life Insurance). It provides life protection as well as investment that yields higher interest returns than time deposits.
> START EARLY. The longer the period, the more time you give for the interest income to grow your money. The earlier you save big, the more money you’ll accumulate in the future. This is why as for the case of retirement planning, it is always advised that you start early.
Take two friends of the same age, and we’ll call them Joshua and Kevin. Joshua decides at 25 that he’s going to start placing Php 12,000 yearly to his retirement account and end at age 35. If his investments return a hypothetical 10% per year, by the time he’s ready to retire, he’s got Php 2,507,274.53 at age 60.
Kevin, on the other hand, had not thought much about his retirement until age 40. When he realizes, he’s got to start planning for his future, he decides to place the same amount of Php 12,000 into his retirement account and end at age 60. If he earns the same hypothetical 10% return per year, he’s got Php 831,632.99 at age 60.
“The early bird catches the worm.”
As you can see, even though Kevin’s total contribution is twice more than Joshua, he ended up with less accumulated money come retirement. If Joshua continued to save even more, he’ll be able to reap more benefits out of compounding.
Compound interest is the key to growing your savings and investments for you to achieve your financial goals. Start now and contribute what you can. Even small savings of Php 1,000 per month add up over time and make a huge difference to your financial future.