The Power of Compound Interest – How It Can Help You Save Money
At some point you might have come across the term compound interest. A simple calculation and a wise decision can help you save and grow your money in the long term.
Let us break it down so you can understand the magic of compound interest, starting with defining what compound interest actually is.
What is Compound Interest?
Compound interest refers to “interest on interest”. Compound interest is the interest on a loan, or a deposit calculated based on the initial principal and the accumulated interest from previous periods. It can make a sum grow faster than simple interest, which is calculated only on the principal amount.
The result of reinvesting interest, rather than paying it out, is compound interest. It helps money grow faster because, in addition to already earning the returns on the money you have invested, you also get to earn returns on those returns at the end of every period, which could be daily, monthly, quarterly, or annually.
What Is the Power of Compound Interest?
In order to understand how compound interest works, all you need to know is the returns or interest generated on the principal amount (in the first period) is added back to the principal amount to calculate the interest for the following periods. Thus, helping it grow faster.
This investment creates a chain reaction by generating returns on the returns for as long as the money remains invested. The longer, the better.
Here is an example to understand how compound interest works and the power of compound interest:
Two investors, Alberto and Benny, are looking for opportunities to create more money with an initial investment of USD 10,000. They spot an opportunity where the interest can be earned at 10% per year. Alberto opts for interest to be calculated as compound interest, while Benny opts for interest being calculated as simple interest. They both decide to stay invested for a period of 10 years. The following table shows the returns for Alberto and Benny based on their decision:
|Returns + Initial Investment||$25,937||$20,000|
As the period of 10 years comes to an end Alberto gets to accumulate $15,937, 59% higher than Benny’s return of $10,000.
While the power of compound interest is interesting, the biggest thing an investor should appreciate in compounding is the value of the time it requires.
How to Use the Compound Interest Calculator?
Compound interest can be calculated using a simple formula to calculate the Future Value (FV)
Herein, P is the principal amount, r is the rate of interest per year, n is the number of times in a year the interest gets compounded, and t is the number of years.
Let us understand this better with the help of an example.
Maria invested $50,000, with an annual interest rate of 10% for a time frame of five years. In the table below you see the interest earned every year and the total balance of $80,526 at the end of the 5 years.
|Year||Initial Balance||Interest Earned||Ending Balance|
Similarly, we can calculate it using the compounded interest formula
How to Use Compound Interest to Your Advantage?
A few simple ways to use the power of compound interest to your advantage are:
- Focus on savings in the first ten years of your career: Whether big or small, mutual funds or stocks, it just does not matter much at this stage. Simply having a savings account means that you are in the game from the beginning. Your savings are the main way to grow your money. It is therefore advisable not to focus on being an investment expert early on but focusing on frugal living and adding small amounts to your savings. That goes a long way over time.
- Be patient: The return on an investment matter more towards the end of the saving years. So, while compounding is a powerful tool, you can see decent outcomes from compound interest only after a substantial period of 10 to 25 years or more. Patience is the key since, in these later years of a savings plan, the investment returns overtake savings as the main engine for growing your portfolio. Therefore, you can gain better by lowering investment costs and sticking with a sound investment strategy.
- Do not forget to invest in yourself: While saving money and investing is great for the long haul, do not miss out on the monetary returns by investing in yourself through professional courses and developing investment skills for better paying jobs. Careers that are financially and personally rewarding can increase your salary significantly as you get older.
- Investment costs: Investing in funds usually has a cost from a few basis points for index funds or non-actively managed funds to 1 to 2 percentage points for actively managed funds. The 1 to 2 percentage point difference can become a large amount over the long term, evaluating if the historical performance and the future outlook of that fund warrants the extra cost.
What Are the Benefits of Compound Interest?
The biggest advantage of opting for compound interest is that the longer your money sits in a compound interest account, the more it will benefit you. However, how often interest is compounded also makes a significant difference. Annually compounding interest will grow slower than an investment where the interest is compounded quarterly.
Another benefit of investing money in compounding interest accounts helps in long-term cash management plans as it can be a source of funding large purchases. Similarly, understanding the concept of compounding interest can also help save money in a better way.
Why is it important to save now?
While saving money is always a good idea, saving money early on helps you save for a more promising career. You can use the money to pursue higher education later or even start your own business after gaining expertise. It also provides long-term security and financial independence at a later stage. Also, saving leads to minimizing financial risks, allowing you to be more at peace during your later years.