Compound interest

1. What is compound interest

Simple interest is derived by using a percentage times the principle sum. The concept of compound interest is earning interest on interest. In investment, the interest or dividend that is earned from the principle invested amount can be reinvested for compounding to take place. Reinvestment of earnings and time are the two factors needed to see the effect of compound interest.

2. Using compound interest on investments

For an investment amount of 10,000 at 6% returns, the first year earnings is 600. Rather than spending this earning, you know about compound interest so the money is reinvested back. The second year interest is 636. It is 36 more than the first year and may look like peanuts at first, but bear in mind you did not have to put in any extra effort to earn the extra amount. On the third year, the returns is 674.16 and that is 74.16 more than the first year. By the end of twenty years, an investment of starting amount 10,000 will become 32,071.35 by repeatedly reinvesting.

Other than reinvesting the earnings, topping up the principle amount every year will bring the investment more explosive growth. Besides the principle amount of 10,000, let us add on 5,000 every year to the investment with 6% returns. At the end of ten years, the amount will grow to 87,766.69 where invested amount is 70,000. By twenty years, the amount will be 227,034.99 where invested amount is 130,000. This will continue as long as you keep reinvesting and earning interest. 

The earlier you start investing, the more can be reaped from compounding. Take two individual cases as example. Investor A starts investing at age of 25 at 10,000 principle, top up 5,000 annually at 6% returns, he will have 333,700.62 by age 50. Investor B starts a little later at age 30, he tries to catch up by investing more at 12,000 principle, tops up 7,000 annually at 6% returns he will have 311,434.71. Total amount invested by investor A is 135,000 and 152,000 by investor B. Even though investor B put in more money, his returns are lesser. By investing early, the accumulated earnings itself accrue even more earnings. 

3.Using compound interest to work for you, not against you.

On the other hand, debts have the same effect against you. When credit card companies charge you interest for the outstanding amount on your credit card bill, it is also compounding if you do not repay back. Cultivate prudent spending habits and your older self will thank you for it. Make your money work for you instead of against you.