What is Compound Interest and How Does It Work
Compound interest is the most powerful tool in the world of investing. It can help you build generational wealth through the power of time. In fact, it was even deemed by Albert Einstein as the “Eighth wonder of the world”. For someone genius and esteemed as Einstein saying this, it is indeed powerful.
If you’re a young and aspiring investor, compound interest can be your best friend along the way since time is on your side. The earlier you invest, the more you can expect your money to snowball exponentially down the road.
What is compound interest
Compound interest is the interest you earn on the money you’ve saved or invested plus the interest you’ve earned on your interest.
This works in both saving and investing. However, we both know that investing is the best way to accumulate wealth since the potential returns are much higher than saving your money in a piggy bank or even a traditional savings account. Thus, compound interest works the best when you invest it.
Imagine just holding on to your cash in a traditional savings account, which gives around 0.25% interest rates at most, versus investing it. Sure, your money compounds in your account but compared to investing it in mutual funds, bonds, stocks, or other forms of investment, it’s just a measly amount.
Think of it like a snowball on the top of a hill, drop a small amount at the top, and see it grow as it rolls down. The sooner you invest, the sooner you can start making your money work and compound later down the road.
How compound interest works
Let’s say you’re 20 years old and you plan to retire when you’re 60. This means that you have 40 years to save and invest. If you put PHP 1,000 per month in your traditional savings account for 40 years (given an annual return of 0.25%), you’ll have saved PHP 506,524 by the time you’re 60. Not bad!
However, if you invest your PHP 1,000 per month with an average annual return of 7% for the same amount of time, you will end up with PHP 2,578,289. You’re an instant millionaire by the time you retire. That’s over a million difference! Now, can you imagine if you invested higher than PHP 1,000 per month?
There are many compounding interest calculators online. You can try this calculator and see for yourself.
Time is your best friend
The more time you have, the more time you’re allowing your money to compound over time. As we’ve discussed throughout this article, money can grow exponentially. How much you can leverage that exponential growth depends on how early you invest.
For young and aspiring investors, time is on your side. You still have 30 plus years to grow your investments and you will still have time to enjoy the fruits of what you sow by the time you retire. The first thing you’ll know by the time you retire is that compound interest made you rich.
Invest now, no matter how small
A common investing saying is “the best time to invest was yesterday, the next best time is today, and the worst time is tomorrow”. If you feel you’re missing out on the gains yesterday or regretting that you should’ve invested earlier, don’t fret out, as the second-best time is to invest today. No matter what your age is, you can start making your money work for you and become rich in time with compound interest.
If you don’t know where to start, we recommend that you learn the basics and fundamentals of investing first. You can start by browsing our investing blogs here.