Finance 101: What is compound Interest? Does it work 🤔?

Yuyumoe

Do you ever feel like — the deck is stacked against you financially? True, it’s not easy being a 20 —something in today’s economy, or is it?  If you want to learn one thing that can put your money to work for you. It’s called “compound interest,” you might have heard of it, but do you know how it can help you exponentially grow your wealth? Let’s find out!

Compound Interest Definition

Time means money peeps.

There is an often-told story that when Einstein was once asked what mankind's greatest invention was, he replied: "Compound interest." He called compound interest the "8th Wonder of the World." Well, I just call it the super-simple way to know your socks off financial freedom. Or, the simplest definition of compound interest you'll ever hear: "Money makes money. And the money that money makes, makes money."

Compound Interest Formula

Here’s the formula for compound interest but don’t let the math fool you. This is one of the easiest ideas to understand and the math here is pretty basic  — so no stress plzz 💆


The data never lies.

The following compound interest formula is used to calculate the accrued interest and principal:

A = P x (1 + r/n)nt

Where,

A = Total amount (principal and interest)

P = Principal (starting amount)

r = Annual interest rate as a decimal

n = Number of compounding periods per year

t = Number of years

If you want to create a compound interest calculator in Excel, you can use the following formulas:

Total amount= P*(1+i)^n)

Interest amount = ((P*(1+i)^n) – P)

The Power of Compound Interest

Like I mentioned earlier, compound interest helps you exponentially grow your wealth—or against you if you're paying off debt. In other words:

  • Any amount subject to compounding interest or growth will grow at an accelerating rate.
  • The higher the rate of growth, the faster the growth will accelerate.
  • The more often the interest compounds, the faster the growth

Unlike earning a static salary that only grows at the rate of inflation, compound interest is so powerful that it allows your capital to expand from the amount you save and invest. Similarly, compounding your money daily will give you higher compound returns than doing it monthly or annually.

See the example below for how the different frequencies impact the growth of $10,000 (unrealistically high, i know but just for the sake of understanding) with a 3% interest rate.

  • After 1 year, you'd have $10,300. You'd earn $300 in interest.
  • After 5 years, you'd have $11,593. You'd earn $1,593 in interest.
  • After 10 years you'd have $13,439. You'd earn $3,439 in interest.
  • After 20 years you'd have $18,061. You'd earn $8,061 in interest.

You will also realise from the example that 10 years to twenty years compound returns can turn a modest amount invested in a diversified portfolio into a sizeable nest egg!

Double Your Money: Rule of 72

If you're considering making an investment with a given interest rate, you can use the Rule of 72 to figure out how long it will take to double your money. For example, if the interest rate is 15%, it will take 72/15, or 4.8 years to double your money. If you earn 5%, it will take 72/5, or 14.4 years to double your money.

Compound Interest Application

I know what some of you are thinking. $1,000 per month sounds like an awful lot for a 23-year-old to save. I hear you. It is a lot. But, it’s not as much as you think if you know how to invest your money in the right way.


How can I save that much?

Say you put $1,000 into a savings account with a 5% interest rate that compounds annually. After that first year, you make 5% and will have $1,050 — an extra $50 plus the initial $1,000 in principal.

At the end of the second year, you make another 5% and will have $1,102.5 — an extra $52.5 plus the $1,050 from the previous year. An extra $2.5 isn’t something most people would get excited about but look at how that money grows.

By the end of the third year, you make $157.62 more in the account and will have a sum of $1,157.62 (without adding any more of your own money after your initial investment).

Isn't it great that even though you didn’t make any deposits, your earnings still accelerates? Likewise, instead of calculating interest based only on your original principal, compounding interest calculates your annual interest based on the principal plus any previous interest you earned on that principal. So you can thank compound interest for that.

Fortunately, you also do not need to be a math whiz to put the formula to work as most of us (probably everyone) should be having a bank account, so many banks especially online banks, interest compounds daily and gets added to your account monthly, so the process moves even faster. But if you are curious to find out yourself, you can use the compound interest calculator here

Bottom Line: Not So Crazy Tips 😎


Multiply Your Money

Compounding is a champion in accumulating wealth, yes, you can slowly get rich by it but how much is rich depends on person to person. But one thing remains the same for everyone (unless you are paying debts), compounding works like a charm for everyone without putting much effort. Having said that, here are three simple tips you should start taking advantage of:

  • Save early and often: It's better to start at the age of 23 than 33, you will get more time for your portfolio to grow until your retirement.
  • Check the Annual Percentage Yield (APY): APY rates are usually higher than interest rates so compare bank products such as savings accounts and CDs. Also look out for the savings account that compounds daily.
  • High initial investment: Of Course, invest once but big.

Thanks for reading the blog and if you find it insightful, please do share with your mates. Sharing is Caring!

Disclaimer: The author is not a financial advisor and the information provided is general in nature and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs or financial situation.

Turn your learnings into practice
Try WeMoney today.

Join the financial wellness movement.

Be a part of Australia's fastest growing financial community.
Thank you! You will receive an email shortly :)
Oops! Something went wrong while submitting the form.