Compounding has been regarded as the magic word that moves the financial world, but is it? Do you know what it is, and could it possibly work for you?
A principle developed by Albert Einstein, one of the smartest guys to have walked the face of the earth, the principle of compounding interest is believed to hold a lot of potential with regards to increasing your earnings or value in the future. The principle of compounding interest is also said to be one of the greatest mathematical discoveries ever made, and the best bit is that this principle works for everyone who employs the principles of delayed gratification, or rather, the promise of more returns tomorrow for something you forego tomorrow.
Contrary to conventional wisdom, the concept of compound interest is quite simple, it applies to everyone, and anyone could benefit from it.
What is compound interest?
Here is what the concept of compounding interest is all about – essentially, whenever you invest your money, you will earn interest on that capital investment, and in the next year (if you don’t withdraw your interest), you will earn interest on your original investment/ the principal amount, as well as the interest from your first year. In your third year of investing, your earnings will be made up of the interest on the capital initially invested, plus earnings on the two years’ worth of interest. Basically, you have your money working for you and growing; the longer you keep that money in your investment pot.
The compounding principle is a lot like the snowball effect but instead of a snowball you are looking at your capital investment that will grow bigger as it rolls downhill. And even when you have the tiniest bit of snowball in the beginning, the snowball will end up being one of the biggest snowballs given enough time.
To understand the compounding interest, you need to understand how this formula works. The good news is that this formula is not as hard to decipher as you think. However, you should keep in mind that this is the greatest mathematical discovery Albert Einstein was referring to. In the financial world, this formula could be your one-way trip to financial independence.
So, how exactly does this equation work in the financial world?
Well, for your journey to financial independence using this equation, you require three important inputs, financial elements that could change your life. These elements include the amount of money you will invest (principal amount), the expected rate of return, and the time you have for your money to grow.
If you hate maths, it’s quite understandable if you frown at the next section of this article, but we’ve got to address it. The good news is that you don’t have to do any maths, and you also get a simple example to work with.
Examples of compounding interest for different kinds of investments:
If you have £1,200 in a savings account earning 0.1% annual interest today, you will have £1,212 after 10 years and £1,249 in 40 years.
The same investment of £1,200 invested in Certificates of Investment account with a rate of return of 2% earns you £1,463 after 10 years or £2,650 in 40 years.
While a £1,200 investment at the stock market with an expected return of 9% pa would leave you with £2,841 also in 10 years and £37,691 in 40 years.
With these examples, you can clearly see that putting away a little money that you’d otherwise use frivolously would result in significant savings in 10 or 40 years.
But that isn’t the best bit – the best thing about all this investment thing is that your potential earnings would be significantly higher if you invested the £1,200 to your investment portfolio each year. So, adding to £1,200 to your savings account each year would mean having £50,246 in your account after 40 years, thanks to your consistent investments and the power of compounding interest. And if you keep adding the same amount in your stocks portfolio, then the initial £1,200 and the subsequently added £1,200 would mean earning as high as £479,642 if working with a return rate of 9%.
That, right there, is the perfect example of how compounding interest works and how you could use this principle if you are determined to attain financial independence early in life.
In essence, the compounding interest principle pays compound interest on the money you invest by returning the interest earned back to the investment basket, growing both the principal and the interest. Typically, these returns are earned monthly, and in other cases, daily.
The Compounding Investment Returns
When investing in the stock market, your earnings/ returns vary depending on the market and the changes in the value of your investment, meaning that you never earn a steady interest rate. You will earn a good return every time the value of your investment goes up.
Note, however, that the changes in the market don’t mean that you get to shy away from investing in a stock. Why? Well, first, the stock market often always promises the highest investment returns compared to other investment instruments. Also, there’s the power of compounding interest, which allows your returns to earn interest just because you are leaving your money in the investment pot. The interest will be compounded for as long as you keep your investment.
Now that we have the basics out of the way, here are the Laws of Compounding, you should be aware of.
Factors Affecting the Compounding Interest Returns
Generally, there are three things that affect the returns from compounded interests. These are – interest rate, time, and tax rate.
The interest rate or the rate of return earned on investments or the profits earned. In this case, if you invest in stocks, the interest/ returns earned would represent the total profits gained from dividends and capital gains.
Time – the power of the compounding interest lies in time. So, if you keep your money invested for longer and in an uninterrupted manner, then you will have a bigger fortune. The returns from the compounded interest work a lot like a tree – that tree you plant today will be huge in 30-50 years than it would be if you plan to grow it in the future.
Tax rate and also the timing for the taxes payable to the government. Obviously, you’d end up with more money if you didn’t have to pay any taxes, or if you wait until the end of the compounding period rather than before the end of that period.
Rules of Compounding Interest
The compound interest concept is basically the foundation of the time value for money – the financial element which states that the value of money always changes to each person, depending on when one receives that money. In this case, earning £10 or £1,000 today is very much preferable to getting the same amount of money 5 or 10 years from today. The reasoning behind this is that if you received that money today, you could invest it in different instruments, earning interest income and dividends from the investment. With the earnings from the compounded interest, you can use the money on the things you gave up, or even use it to pay off that small debt that’s been keeping you done.
Therefore, you could think of postponing the receipt of that £1,000 in annual interest to more money in the next 20 years. This is a principle of economics called opportunity cost.
The best way for you to enjoy the benefits brought about by compounding interests involves starting early. Putting your money in early enough means that there is more time for the compounding to take effect, hence a promise of bigger returns. So, if you save £10 each month from age 20, it means that at 50 or 60, you’ll have more money saved up than someone who puts away £10 from the age of 30.
Don’t overlook the small differences in returns
In the long-run, investing at 8% or 9% makes all the difference. If you are unsure, you could use one of the online calculators for compounding interest for information on just how big the difference is.
The Rule of 72
One of the biggest and the most important rules regarding compounding interest and investments has to be the Rule of 72.
Essentially, the Rule of 72 is the simplest way of determining how much time it would take an investment to double in value, given a fixed annual rate of return/ interest. To determine the time it will take, you’d have to divide 72 by the annual market rate of return. Generally, investors would use this approach to determine the amount of time it would take for their investments to double.
In this case, the rule of 72 states that if you invest £10 today, at a fixed rate of 10% annually, you will double that amount in 7.2 years (72/10). Note, however, that in reality, it would take 7.3 years for that money to double if you use the equation – ((1.10^7.3=2).
You should also know that the Rule of 72 is more accurate when you are working with investments that promise lower rates of return.
Never Squander your Inheritance
You might have earned that money or feel like you can do whatever you want to do with it, but the truth is that you must be smart about all the money you have. If you must enjoy the money, find a balance between investing in your future and your current need for enjoyment.
As mentioned above, the concept of compounding interest leverages the time value of money. So, even though your initial investment is too little and you don’t like the numbers after the first year or the first five years, your patience will pay off in 40 years.
How to Enjoy the Compound Interest Benefits
Pay off your debts fast and pay extra whenever you can
Debt is the one thing that could slow down or curtail your journey to financial independence. Therefore, even as you work on saving and investing more money, you need to pay as much as you can to get rid of your credit card debts. If you pay the absolute minimum, you will not make much difference in the interest, and your balance might actually grow instead of reducing. Also, if you are still paying off your student loans, you must avoid the capitalization interest charges by paying off the interest to prevent further accruals, even as you pay off the principal.
If you must borrow, go for the lowest interest rates
Interest rates on loans determine the growth of your debt, as well as your repayment period. It also affects your monthly payments. Therefore, if you have to borrow some money, make sure that the loan will not affect your ability to repay the money or that it won’t increase your debt to crippling levels.
Start saving early and consistently
If you want to grow your savings to an impressive number in the next few years, you can make time your best friend by saving now. Don’t think of how things could have been better and different if you started saving 10 or 15 years ago. Just start today. Put that £10 into an investment instrument today and add to your investment each month, week, month, or even daily. And as you do that, remember that the trick is to leave that money untouched, regardless of how badly you need that new car. Time is the factor that will encourage the growth of your money.
Always Check the APY
APY, also the annual percentage yield is an important factor that you must keep in mind at all times when investing. It’s a crucial part of the compounding equation, and the best part is that it makes it easier for you to compare the interests offers by CDs and bank savings accounts. The good news is the APY is always higher than the interest rate, and banks always publicise the percentage. So, shop around and only settle when you are certain that the APY offered is the best you can find.
Your ticket to financial independence lies in the concept of compounding interest. To leverage the power of this concept, be patient, consistent, and save as much as you can today rather than tomorrow. So, put that £10 in a savings account today and watch the magic of the compound interest take its effect on your money.