“The miracle of compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
– Albert Einstein
In Singapore, we are constantly looking for ways to grow our wealth. Many of us have heard similar advice of how investing our money early on in life can reap large, exponential rewards in the future. But how exactly does this work and how big is the impact if we start investing early?
The engine that drives exponential returns on our investments is none other than the concept of compound interest. Before you even start investing your hard earned money, you need to understand how the true power of compound interest comes about.
This simple concept can help you turn a small investment into a significant nest egg over time, and it’s never too early (or late) to start.
What is Compound Interest and How Does it Work?
Compoundi interest refers to the interest you earn on your principal (the original amount of money you invest) plus any interest that has accumulated over time.
For example, if you invest $1,000 at a 5% annual interest rate, after one year you would have $1,050. The following year, you would earn interest not only on your original $1,000 investment, but also on the $50 in interest that you earned in the first year. This is the compounding effect in action.
The $50 may not seem like a big amount right now, but over a larger period of time you can truly see how it starts to shine.
How to Calculate Compound Interest
The formula for calculating compound interest is fairly simple:
FV = P*(1+R/N)^(N*T)
- FV – Future Value of the investment
- P – Principal (the initial amount put in)
- R – Annual Interest Rate
- N – Number of times interest is compounded per year
- T – Time duration (in years)
The calculation for an initial investment of $10,000 at a rate of 5% over 15 years will be as follows:
FV = $10,000 (1 + 0.05/1)^ (1 * 15) = $20.789.28
This formula is assuming you use a lump sum investment at the start. There are other more complex calculators available online such as this, where you can also input monthly or yearly contributions to see how your money will grow.
The Power of Compounding Over Time
Compounding interest is often referred to as the “miracle of compounding” because it has the potential to turn a small investment into a large sum over time. To see how this works, consider the following example:
If you invested $10,000 at a 5% annual interest rate, after 20 years you would have $27,126.40. This may not seem like much, but if you continued to invest the same amount each year for another 20 years, you would end up with $73,584.17.
As you can see, the longer you invest, the more your money grows thanks to the compounding effect. The real power behind compound interest lies in the time that it is being put to work.
This is why you often hear people advise you start early, for time is on your side at a younger age.
How to Maximize the Power of Compound Interest
The key to maximizing the power of compounding interest is to start early and invest regularly. The earlier you start, the more time your money has to grow. Additionally, regular investments, such as monthly contributions to a savings account or a retirement plan, can help you take advantage of the compounding effect.
Another way to maximize the power of compounding interest is to invest in a high-yield savings account or a fixed deposit account, which typically offer higher interest rates than a traditional savings account. You can also consider investing in a diversified portfolio of stocks and bonds, which can provide higher returns over the long-term.
Start Investing Early to Take Advantage of Compounding!
Compound interest is a simple yet powerful concept that can help you build wealth over time. By understanding how it works and making smart investment decisions, you can turn a small investment into a significant nest egg. So don’t wait, start today and watch your wealth grow!