Compound interest is sometimes thought of as a miracle worker when it comes to savings and investments. It has the power to convert a small concerted amount of savings effort into a large and comfortable retirement value. By putting aside money sooner rather than later, you will generate greater returns on your money – at an accelerated rate.
Compound interest works rather like the snowball effect. It is difficult to gather savings at the start but once some momentum is formed, your savings will generate interest and then there will be interest on the interest and you’ll practically be rolling in dough..
The simplest way to think about interest is from a savings account. When you place your money into a savings account, you are earning interest over time on your investment. In a similar way, the returns on your stocks and bonds can be thought of as interest when the returns are calculated as a percentage of the value of the asset. In all these cases compound interest is the return that is generated on your return.
How compounding works
To capture the benefits of compounding interest, you need to be patient and disciplined. It is the primary goal of conservative investors – who are looking for steady and stable levels of returns with minimal risk. The key to maximising returns is to reinvest the returns on your investments. If you are paid a cash dividend use it to buy more stock – don’t spend it on a frivolous activity. The way compounding works is you keep building gains on top of gains as well as on your initial investment so that your returns are in a larger amount year on year.
The best way to understand why is with an example. If you deposit S$100 in a bank account that pays 5% annually after a year your investment has grown to S$105 – a return of $5 for the year. If you then continue this for another year you gain 5% on $105 – which is a return of $5.25.
As you can see in the table below that after 7 years the total return you have achieved in S$40.71. If after the first year you took your S$5 return out of the account but kept your S$100 in and continued this each year your return after 7 years would be $35. This is a 16% difference in the return of your investment by using compound interest and can add up to huge amounts over time!
Compound interest gives peace of mind to all investors. In this type of investment your money continues to grow and grow and the risk is low. As time passes by you gain returns on your money. The key is to stay fully invested and keep reinvesting the returns you make each month, quarter or year, whatever the case may be.
The power of compounded interest – how is it useful?
The truly amazing thing about compound interest is that it means that any one of us from any walk of life has the ability to save and build wealth substantially for our retirement. Whatever your background, you are able to take advantage of the benefits of compound interest – as long as you apply discipline and time to your investments.
As an example, consider a 25-year-old who earns S$ 68,000 a year – if this person saves and invests 10% of their income each year until they are 65 they would have a massive S$3, 336,696 saved for their retirement, assuming a rate of 10% return on their investments. Compound interest means you make gains on your gains and over time this is very powerful and very profitable for your investment portfolio.
A word of caution:
Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
This means you should be aware of who may be benefitting from compound interest when it comes to your debts. If you are constantly trying to pay off loan and credit card debts but the balance never seems to go down, this is because of compound interest that your loan provider is adding on to your debt burden – the amount you owe grows and grows and you pay interest on interest – working out very costly in the long run and very damaging to your financial health.
Be very cautious about the debt burdens you are taking on as compound interest has the power to harm in this setup. Understanding compound interest and harnessing its power to work for you rather than against can add up to a very comfortable retirement for you and your family later in life.
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