Compound Interest

Compound interest is one of the most important concepts to understand if you want to manage your finances. It can work for you (by helping you to earn a higher return on your investments or savings) or against you (when you have interest compounding on the Ringgit that you have borrowed).

What Is Compound Interest?

Compounding is a process of growing. If you understand the “snowball effect,” you already know how something can build upon itself.

How Does Compound Interest Work?

Compound interest is interest earned on money that was previously earned as interest. This cycle will lead to an ever-increasing interest and account balances(also known as exponential growth).

Let us illustrate this concept of compound interest.

I am sure that you know that banks usually give us interest for the Ringgit that we keep in them. For example, in year 1, you deposit RM1000 into a savings account with a 5% interest. Over the year, you will have earn RM50 in interest. If you didn't do anything to your deposit plus interest earned, you will be earning another 5% interest on both your deposit (RM 1000) and interest earned (RM50). Thus, you will get RM52.50 interest instead of the RM50 in the first year.

The process will continue as long as you don't take out the Ringgit from these savings accounts.

On the other hand, if you are borrowing Ringgit from the bank, the compounding will work against you. You will pay more interest on the money that you have borrowed. Also, if you are paying the minimum payment only, the loan balance will increase over time.

How to take advantage of compound interest?

The most simple way to take advantage of this compound interest is to start saving early and often. When growing your savings, time is your best friend. It will take a while for it to get momentum, but once that momentum is built, there will be no stopping for it unless you take all it out.

In some cases, starting early means that you don’t need to save as much as somebody who waits to start saving. Even if you quit saving at some point, your head start can pay dividends later. Be patient, leave your money alone, and think long term.

Another way to take advantage of this compound interest is to pay off your loans and debts as early as you can. Keep it in mind that paying the minimum on your credit cards will cost you dearly. This is because you will be barely making a dent on the interest charges and your outstanding balance could grow more and more.

In addition to affecting your monthly payment, the interest rates on your loans will also determine how quickly your debt grows, and also the time it takes to pay it off. It is also very difficult to contend with double-digit interest rates. So, if possible, consolidate your debts and lower your interest rates while you pay off debt.

Compounding can help you grow your money, but it has its limit. To really take advantage of compounding, you need to

1. save a starting amount of Ringgit,

2. deposit it into an account,

3. earn interest on your savings, and

4. repeat the process over and over again.

What Makes Compound Interest Powerful?

Compounding happens when interest is paid repeatedly. The first one or two cycles are not especially impressive, but things start to pick up after you add interest over and over again.

The frequency of compounding matters. More frequent compounding periods, daily, for example, have more dramatic results. When opening a savings account, look for accounts that compound daily. You might only see interest payments added to your account monthly, but calculations can still be done daily. Some accounts only calculate interest monthly or annually.

Compounding is more dramatic over long periods. The longer it is left alone to grow, the better the result will be.

The interest rate is also an important factor in your account balance over time. Higher rates mean an account will grow faster.

The amount of money does not affect compounding. Whether you start with $100 or $1 million, compounding works the same way, and your account balance looks the same if you chart the growth over time.

Let us look into a case study:

Johan started saving RM5,000 every year at the age of 18. He stops when she turns 28. Over a period of 10 years, he has saved a total of RM50,000. Additionally, he is also earning a 10% interest from his savings annually. At the age of 58, he has would have accumulated a total of RM1,529,542.01.

Adam has also been saving, but he started at the age of 28. Unlike Johan, he saves RM5,000 every year until he retires at the age of 58 years old. This means Adam has been saving for 30 years with a total saving of RM150,000. He also enjoys an interest rate of 10%, but at the age of 58 his total amount is RM904,717.12.

Although Adam have saved up 3 times as much as Johan, Johan still has more. He only saved for 10 years, when Adam saved for 30 years. The reason for this is the snowball effect. The effect is so drastic that Adam is not able to catch up with Johan, even if he saved for those 20 years extra.

My best advise for you is to start saving now. Save as much as you can and try not to touch the money.