One of the magical words that we often hear these days – compound interest. So, what exactly is compound interest and is it as magical as it sounds?
Compound Interest V.S. Simple Interest
What is compound interest? As the name suggests, compound interest works by the compounding of the principal amount. However, the magic comes when the interest earned is compounded back into the principal.
The magic? When the new interest generated is based on the new compounded principal!
On the other hand, simple interest is generated based on just the base principal which will not be accumulated.
Let’s say you have $100, with a 5% interest per year.
This will be the difference between a simple interest and compound interest after each year
As you can see, compound interest gives you a little more each year which allows your principal amount to grow at an exponential rate with time.
How Can It Be Useful To You ?
Albert Einstein once said
“Compound Interest is the 8th Wonders of the World”
There must be some reason why. Let’s find out some of the reason how it can be useful today!
1- Beating Inflation
Have you realised how things are getting expensive these days ? Yes, inflation is here to stay.
The $1 you have today will not be able to buy the same amount of things in the future. Just like how we’ve heard for the millionth time “last time my chicken rice costs be only $2!”
Hence, it is even more important to have our money grow to beat the rate of inflation.
2- Time is Money
As the saying goes “Time is money”. Indeed it is, and hence it is important to have our money compound itself too when we are saving.
Putting our money in an account which compounds by itself over time allow us to let it grow as time passes by.
The Earlier you start, the faster it grows !
As we mentioned, time is money. Indeed it is. By starting to let our money compounds by itself, the more time we give the money to compound by itself.
This can work wonders especially at a young age when the time horizon is on our side. All we need to do is to start to commit and let time do its job.
What are some examples of Compound Interest ?
Now that we understand how compound interest can work in our favour, what are some examples of compound interest ?
Compound interest can come in many ways
It can be from a dividend investments, pure savings accounts or dollar cost averaging into an index fund.
For instance, investing in dividend paying stocks will allow these dividends (bonuses) to be reinvested back by itself which gives you a bigger sum of dividend the next time (power of compounding).
Some Things to Note
As you can see, compounding effect works by itself with not much monitoring and work to be done. Patience is just the key here. However, before you start committing yourself, here might be some things worth finding out.
1- Interest
Find out what’s the interest rates. The larger the interest rates, the faster it allows your money to be compounded
2- Starting Principal
Yes, although the money accumulated will largely benefit based on the interest rate, however the interest rate will be applied to the starting principal to start with.
3- Frequency of Compounding
This can be tricky, but simply put, it is the frequency at which the interests are issued. The more frequent it Is, the more interest can be generated.
This can be annually, bi-annually, quarterly, monthly or even daily!
Planning Ahead
You may have realised the wonders of compound interest, and indeed compounding can help us not only build our wealth but also help us plan and save for our retirement at a much faster rate.
However, planning ahead will take time and we all may have different financial situations.
Questions like “where should I put my money”, “How long should I put my money in this instruments” or “Is this a good rate/deal?” are questions we often have.
Indeed it can be overwhelming and confusing. But we hope that you have learn a thing or two from this article. Still keen to find out more ?
Chat with us today.
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