A Primer on Compounding Interest – Strategies for the Prudent Investor

1 March 2017


Carnival has come and Carnival has gone. Costumes were bought, fetes were had, paint was spilled along with some level of alcohol, and, in the end, everyone’s wallet feels a little bit lighter. It is now time for most of us to start saving again for next year’s celebration. But what if it did not have to be that way? What if you had saved up enough that you did not need to save anymore for Carnival but instead could save for yourself and still participate? This is where the magic of compounding interest comes in. Follow along to learn about one of the simplest and yet the most important aspect of saving responsibly.

Compounding Interest is perhaps one of, if not the most, useful and powerful tools for generating wealth an investor can have. Warren Buffet, the celebrated investor from Omaha and one of the wealthiest humans alive, when asked how he managed to be so successful, answered without hesitation “compound interest”.   Another story goes that Albert Einstein, the father of the general theory of relativity, described the magic of compounding as “the eighth wonder of the world and man’s greatest invention”.

So what makes compounding interest so celebrated as an investing tool? This is what we will try to explain simply in this week’s blog.

Compounding interest, to describe it simply, can be thought of as ‘interest on interest’. It is the process of reinvesting interest paid on a principal, thus increasing the size of the principal so that the next interest payment, assuming the interest rate remains the same, captures the increased amount.

In technical terms. The formula for compounding interest looks like the following:

[P (1 + i)n] – P

=P [(1 + i)n – 1]

Where ‘P‘ is the principal invested, ‘i‘ is the annual nominal interest rate in percentage terms and ‘n‘ is the number of compounding periods.

Now to illustrate the power (or “magic” as our friend Albert would have described it) of compounding interest, let’s take a simple example. Let us assume we have $10,000 invested in a savings account that pays 2% interest on an annual basis. What would be the total amount of interests generated after five years?

By using the formula above, it would be $10,000*[(1+0.02)5]-1 or to break it down further $10,000*(1.02*1.02*1.02*1.02*1.02) -1 which comes up to $1,040.81 or a five-year return of 10.41%.

On the other hand, if we had invested this $10,000 into the same saving account at 2% but without letting interest recapitalize into the principal (or to put it simply: taken them out as they were paid) the total amount of interest generated after five years would have been $200 a year times five or $1,000 (or a return of 10.00%).

While the difference between $1,000 and $1,040.81 may not amount to much, over longer periods, and at higher interest rates, the difference becomes more and more tangible. The chart below illustrates how much of difference compounding makes:

So what is the takeaway for the average human being? Always reinvest your interest proceeds into the highest paying instrument you have available and with which risk you are comfortable. It will work magic over time!

A word of caution though, while compound interest is an extremely powerful tool for investors, compounding can also work against consumers who have loans that carry very high interest rates, such as credit card debt. As such, always pay your credit card on time if you can, it is not worth the money to wait.

As a bonus, here is another useful formula, the Rule of 72:

The Rule of 72 calculates the approximate time over which an investment will double at a given interest: ‘i, and is given by (72 / i). It can only be used for annual compounding.

For example, an investment that has a 2% annual rate of return will double in 36 years while an investment with an 12% annual rate of return will double in six years.

 

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