Understanding the Power of Compound Interest

This post was originally posted on Planner Bee.

Imagine planting a tiny seed in your garden. With a little water, sunlight, and care, it grows into a towering tree over time, bearing fruit year after year. In the same vein, your savings or investments can also grow exponentially over time.

This is the power of compound interest. By starting with a small amount, your money can grow increasingly larger as it earns interest on itself. It’s like a snowball rolling downhill, getting bigger and faster as it goes.

If you are looking to build wealth, understanding and harnessing compound interest is crucial. In this article, we’ll explore the basics of compound interest, how it works, and why time is your greatest ally. We’ll also discuss strategies that you can use to maximise your financial growth.

Understanding compound interest

The principle is simple: not only do you earn interest on your initial investment, you also earn interest on the interest.

At its core, compound interest is interest earned on both the initial principal and the accumulated interest from previous periods. This creates a “snowball effect,” where your money grows at an accelerating pace the longer it remains invested.

The formula for compound interest is:

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

Where:

A = the future value of the investment/loan, meaning principal + interest

P = the principal investment amount (initial deposit or loan)

r = annual interest rate (as a decimal)

n = number of times that interest is compounded per year

t = time the money is invested or borrowed for, in years

Let’s say you invest S$10,000 at an annual interest rate of 5%, compounded annually for 20 years. Using the formula:

A = 10,000(1 + 0.05/1)^(1*20)

A = 10,000(1.05)^20

A = S$26,532.98

In this example, after 20 years, your initial investment would have grown to S$26,532.98. That is more than double from its initial value, with S$16,532.98 earned purely from compound interest.

Why time is your best friend

The power of compound interest grows exponentially with time.

This is because interest is being calculated not only on your original amount but also on the interest that your money has already earned. As such, the longer your money is invested or saved, the more it grows.

Let’s compare two scenarios:

• Person A starts investing S$10,000 per year at age 25 and stops at age 35, leaving their money to grow until age 65.
• Person B starts 10 years later, waiting until age 35 to start investing S$10,000 per year and continues investing every year until age 65.

Assuming both earn an annual return of 7%, who do you think will have more money by the time they retire?

Even though Person A only actively invested for 10 years, he/she will end up with more money at age 65 than Person B, who invested for 30 years.

This highlights a critical point: the earlier you start, the more powerful the effect of compound interest becomes.

The rule of 72

One way to quickly estimate how long it will take for your investment to double through compound interest is to use the “Rule of 72.” This rule states that if you divide 72 by your annual interest rate, you can estimate the number of years it will take for your investment to double.

For example, if you’re earning a 6% annual return:

72 ÷ 6 = 12 years to double your investment

This simple rule is useful for understanding the time it takes for money to grow and shows how even small differences in interest rates can significantly impact your wealth over time.

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How to capitalise on the power of compound interest

There are several financial vehicles that allow you to take advantage of compound interest. Some popular options include:

• Singapore Savings Bonds (SSBs): Low-risk government bonds that compound over time. The longer you hold them, the more interest you earn.
• Fixed deposits: Banks offer fixed deposit accounts with guaranteed interest rates. You lock in your money for a set period, allowing it to grow with compounding.
• CPF Special Account: Earn up to 5% interest per year on your CPF savings, with the benefits of compounding interest over time.
• Unit trusts: Invest in diversified portfolios of stocks and bonds, which have the potential for long-term growth through compounding.
• High-interest savings accounts: Some banks offer savings accounts with competitive interest rates. By keeping your funds in these accounts, you allow the interest to compound and grow your balance.
• Regular investment plans: These allow you to invest a fixed amount regularly in various assets, benefiting from compounding as your investments grow.

By leveraging these options, you can maximise the benefits of compound interest and grow your wealth steadily over time.

Inflation and real returns

While compound interest is a powerful tool for growing wealth, it’s important to consider the effect of inflation. Inflation reduces the purchasing power of money over time, meaning that while your investment might be growing, the value of what you can buy with that money may be shrinking.

For example, if your investment earns 5% per year but inflation is 2%, your real return is only 3%. In this context, you should focus on investments that not only offer high nominal returns but also outpace inflation, ensuring that their wealth grows in real terms.

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How to maximise the benefits of compound interest

To make the most of compound interest, here are some key strategies that you can employ:

1. Start early

The earlier you start investing or saving, the more time your money has to grow. Even if you can only contribute a small amount at first, the power of compounding will reward your patience over time.

2. Make regular contributions

Consistency is key.

By making regular contributions to your savings or investment accounts, you can ensure that you continue to build your wealth over time. Set up automatic transfers to your savings or investment accounts to take the guesswork out of investing.

3. Reinvest your returns

Whenever possible, reinvest the interest or dividends you earn. By reinvesting rather than withdrawing your earnings, you allow the compounding process to work more effectively.

4. Take advantage of tax-advantaged accounts

In Singapore, accounts like the CPF offer tax advantages that can boost your savings. Use these accounts to grow your wealth while minimising your tax burden.

5. Avoid unnecessary withdrawals

Frequent withdrawals interrupt the compounding process and reduce the potential growth of your investments. Try to leave your money untouched for as long as possible to maximise the benefits of compound interest.

The long-term mindset

Understanding the power of compound interest fosters a long-term mindset.

It teaches that wealth isn’t built overnight, but through consistent, patient investing. This mindset is particularly important in Singapore, where the cost of living is high, and planning for future expenses like housing, education, and retirement is essential.

By starting early and making regular contributions, you can leverage the power of compound interest to build a comfortable financial cushion for the future. Whether through the CPF, Singapore Savings Bonds, or other investment vehicles, the key is to allow time to work in your favour.

Closing note

Compound interest is a simple yet powerful tool that can significantly impact your financial future. Understanding and applying this concept can mean the difference between merely saving money and building lasting wealth.

If you can put into action everything we have discussed in this article, you can harness the power of compound interest to achieve your financial goals. Whether you’re saving for retirement, a home, or a rainy day, the sooner you begin, the more you’ll benefit from the magic of compounding.

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