Albert Einstein was once quoted as saying “The most powerful force in the universe is compound interest”. The problem is that most people on earth do not use compound interest to their advantage. The misconception is that interest is only beneficial on large sums of money or large monthly payments, but if you start early enough, saving little by little can make a huge amount with the effects of compound interest
Compound Interest: Interest on the Interest you Have Already Earned
The heading of this paragraph is the most basic explanation for what compound interest is. By leaving your interest earned to gain further interest, you are in essence receiving money on the bank’s money.
Let’s use an example to better illustrate what compound interest is:
Johnny Receives $1000 inheritance from his grandparents and decides to put it in a fixed term 5 year savings deposit. The savings deposit gives him 10% interest per annum.
End of Year 1
- The $1000 accrues $100 interest leaving Johnny with $1100 for the year which is carried forward to the next year.
End of Year 2
- The $1100 accrues $110 interest, $10 more than the previous year, as the interest from year one also gained interest. This money is carried forward to the next year which calculates to $1210.
End of Year 3
- The $1210 accrues interest of $121. Again, this money is kept in the bank and carried forward to the next year totaling $1331.
End of Year 4
- The $1331 accrues interest of $133.10. Now Johnny Carries forward $1464.1 to the next year.
End of year 5
- The $1464.1 accrues interest of $146.41 leaving Johnny with $1610.51 when Johnny removes his money at the end of the 5 years.
To sum it up, if Johnny had used his interest every year he would have received $100 every year totaling $500, but because he left the interest to gain interest, he received an extra 22% interest of $110.51.
Using the Power of Compound Interest to Make A Little Become a Lot
Although to some the extra $110.51 may not seem like a whole lot of extra money, you must look at in context. Johnny never added any other money to his original investment. This means in 5 years he received over 60% of his money in interest, and in 7 years his money would have doubled. If this inheritance was given to Johnny when he was 5 years old and his parents invested it for him, and he only used it 10 years after he retired at 75 i.e. it was invested for 70 years, that $1000 would be have grown exponentially leaving him with an investment of over $700 000 dollars.
If, hypothetically, Johnny was able to add $1000 every year for that same 70 years i.e. $1 000 for 70 years = $70 000, the amount available in 70 years would be over 9 million dollars. That is the power of a continuous payment used in conjunction with compound interest.
This example is impractical, but shows how saving a little every month or year over a long time can make a massive difference. Your age at the time and period of your investment will therefore dictate how much extra money you will earn through compound interest.
How to Get Even More Benefit From Compound Interest
Now compound interest is powerful, but there are ways to enhance the overall effect and increase the returns that you get from compound interest. By maximizing the time, frequency, interest rate, and continuous contribution your money will grow exponentially.
- We have discussed this before, but basically the longer you can invest your money the more the interest is compounded, and the quicker your money grows.
- This refers to the frequency of when the interest is calculated, and in the example above the frequency was once a year. The reality, however, is that most banks calculate interest more often and this is better for you. It will therefore be ideal to invest in a portfolio that calculates interest daily. In the example above, the 10% interest if calculated daily for the year would in fact be worth about 10.51% annual interest.
- Getting a higher interest rate is the best way to increase your return. This can be done by investing more initially as bank often give preferential rates to larger deposits, or to fix your savings for an extended period of time. Another way to get more interest is to look at higher risk investments like mutual funds or equities, but beware of the risks.
- By adding money every month to your initial savings will over time make the most difference. In our example above, the extra 70 payments of $1000 meant an extra 8 Million dollars over 70 years. An even better way to boost your money is to periodically increase your continuous investment. This means if you are paying $100 every month then every year increase this by 5%. So, the next year you put away $105 and so on, and the power of compounding will astound you when you do this.
Now Your Little Will Go a Long Way
The fact that you are looking at ways to save your money smarter is the first step, and once you understand the power of compound interest, you will be on the road to great benefits in years to come. The best way to calculate compound interest is to download a spread sheet off the Internet or use an online compound interest calculator, all of which can easily be found with a quick Google search.
For those who would like a very rough on the spot guesstimate, there is a great formula called the power of 72. Take the interest rate and divide it by the number 72 and that is approximately how long your investment will take to double. Therefore, if you are investing at 5% interest, take 72 and divide it by 5 which equal 14.4 years before your investment will double. Have fun with these numbers and dream about what you will spend your riches on.
This article was written by Timothy Ng. You can read more of his work at CreditCardFinder.com.au where he has a number of comprehensive guides to all types of credit cards.
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