Here’s How Compound Interest Can Grow Your Funds Over Time
Investors have been putting more money in their wallets through the power of compound growth. Most people are familiar with the concept of simple interest. However, a 2014 survey suggested that only 37% of Asian consumers understand the concept of compound interest – when interest is earned on interest which has already been accrued.
Think long-term goals like retirement, or your child’s education fund. With a longer time horizon, you can turn to the most powerful investing tool of all: compound interest.
The snowball effect
Think of compound interest like a snowball rolling from the top of a hill.
When you first start investing, your capital (the money you start your investment with) may be the size of a football, but over time, as it rolls down the hill, it accumulates more snow (interest) and soon becomes the size of a beach ball!
The beauty of compound interest is that as the snowball gets bigger, the area onto which new snow can stick gets larger – earning you even more interest.
For example, if you invest RM1,000, with a 6% interest per annum (around the same returns as the Employees Provident Fund), here’s how much you’ll have after five years:
| Year | Value at the start of the year | Interest earned | Value at the end of the year |
|---|---|---|---|
| 1 | RM1,000 | RM60 | RM1,060 |
| 2 | RM1,060 | RM64 | RM1,124 |
| 3 | RM1,124 | RM68 | RM1,191 |
| 4 | RM1,191 | RM71 | RM1,262 |
| 5 | RM1,262 | RM76 | RM1,338 |
In the first year, you are only earning RM60 in interest, because that is 6% of RM1,000. However, in the second year, you earn RM64 interest because your principal amount is now RM1060. By the fifth year, you’ve accumulated RM338! The longer you let your money compound, the bigger your return will be.
Why compound interest matters
To highlight the magic of compound interest, and how you can take full advantage of it in your investment, imagine these two scenarios:
| Person A | Person B | |
|---|---|---|
| Starts saving at age | 25 | 35 |
| Yearly investment | RM2,000 | RM2,000 |
| Contribution period | 10 years | 25 years |
| Interest rate | 6% | 6% |
| Total invested | RM20,000 | RM50,000 |
| Portfolio value at 60 (investment + interest) | RM119,929 | RM116,313 |
| Total interest | RM99,929 | RM66,313 |
With the help of compound interest, you can gain greater returns even with a lower total investment amount, if you invest earlier.
This is especially helpful for people saving their money through an investment vehicle over a long period, such as saving for retirement.
Why depend on compound interest
For savvier investors who can anticipate market movements and predict the volatility of the shares market accurately (or as accurately as possible), then the returns will always be greater through the timely shift of money from one asset class to another.
Unfortunately, most people can’t mnage this – at least not consistently. Investors will end up buying expensive and selling cheap, at least a few times in their investment, cutting into their returns.
Furthermore, every shift incurs transaction and trading costs. All these costs reduce your returns. Sometimes, it pays to let your money stay put and just enjoy the compounding effect of your interest!
Knowing about compound interest doesn’t just tell you to save, but it also tells you the manner you should save to take the best advantage of the snowballing effect. Earning 6% on average a year may seem like peanuts now, but over multiple years and even decades, you can easily grow your funds by more than 50%, not to mention successfully combat rising inflation.
Even though putting your money in an investment vehicle will see its value lurch up and down, but at the end of the day, you still win, compared to the cash you save in a bank account.
Compound interest also applies to debt
Be warned: compound interest is a double-edged sword.
When it comes to debt, particularly credit card debt, your unpaid balances can snowball into large debt if you do not repay them on time. For example, if you have a credit card balance of RM5,000, here’s the total interest you may incur for the following monthly repayments:
RM5,000 credit card balance, 15% interest p.a.
| Monthly repayment | Months to pay off | Total interest paid | |
|---|---|---|---|
| Fixed | RM1,000 | 6 | RM196 |
| RM500 | 11 | RM375 | |
| RM250 | 24 | RM789 | |
| Minimum payment | 5% of outstanding balance | 66 | RM1,491 |
The smaller your monthly repayments, the more interest you’ll end up paying. And if you only make the minimum payment every month (5% of your outstanding balance), you’ll take more than five years to pay off RM5,000! This is because the longer you take to reduce your credit card balances, the larger it will grow – the credit card issuer will charge you interest on top of the interest you already owe.
So when it comes to compound interest, you’ll have to learn how to wield it wisely. Start investing as early as you can (after you have saved for an emergency fund and paid off high-interest debts), and avoid taking on unnecessary compounding debt.
This article was first published in 2014 and has been updated for freshness, accuracy and comprehensiveness.
Read more:
Why You Should Start Thinking About Investing In Your 20s
RM1,000 Investment Guide: Where Do You Invest?
5 Low-Risk Investment Options
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