As you enter the world of finance, you’ll hear phrases like “Compound Interest”, the magic of compound interest acclaimed by many. So what the is compound interest actually?
Albert Einstein once said: “The compound interest rate is the 8th wonder of the World. Those who understand it will make money, who do not understand will have to pay the cost for it.
Warren Buffett shared his reasons for being rich as follows:
“My wealth is a combination of life in America, good genes and compound interest.” – Warren Buffett
So what is compound interest (compound interest)? Formula for calculating compound interest like? And how to apply to our life and investment like?
Table of Contents
What is compound interest?
Compound interest is understood as the interest you receive will continue to add to the original capital to continue to earn interest.
Compound interest is the sum of both the principal and the interest earned in the future. Or the future value that I have introduced in my monetary value over time.
If your initial investment amount is 100.000 PHP, with an interest rate of 20% / year then
After 1 year you will receive 100.000 (1 + 20%) = 120.000.
After 2 years the amount you will receive will be: 120.000 * (1 + 20%) = 144.000.
We see that your initial amount is only 100.000, and the first year the profit only earned on this principal is 20.000, bringing the total to 120.000.
However, in the second year, its interest continues to arise in both the original principal of 100.000 (interest on the principal is 20.000) and the interest in year 1 is 20.000 (interest on interest is 4.000) – The second year profit 24.000.
Total interest 2 years will be 44.000 and total amount 144.000.
Continuing, after year 3 it will be 144.000 * (1 + 20%) = 172.800.
This 20% figure is called compound interest: that is, the interest on the principal and the interest on the interest. This is distinguished from simple interest: it is only the interest of the principal.
If compound interest: after 3 years, the total amount is 172.8.000. If it is simple interest, the amount is only 160.000 PHP (100.000 X 20% X 3 years = 160.000).
Are you disappointed to see that the difference between compound interest and simple interest is only 12.8.000 after 3 years? so little?
So let’s look a little further. What happens to 100.000 when comparing compound interest and simple interest over longer periods, like 5 years, 10 years, 20 years, 40 years!
- After 10 years, with compound interest we have: 619.000! Single interest is only 300.000!
- After 20 years, with compound interest we have 3.8 billion, and simple interest is only 500.000!
- After 30 years, with compound interest, we get 23.7 billion PHP and simple interest is only 700.000 PHP!
- After 40 years, compound interest is 147 billion PHP, and simple profit is only 900.000 PHP!
So the longer your eyesight widen, with the growth of compound interest you will become completely rich!
Compound interest formula
Most of the time, what is related to finance has its own rules and calculations. The compound interest formula is no exception! The compound interest is essentially the future value of money.
We have the formula for the future value of money:
FV = PV X (1 + r) ^ n
So the formula for calculating compound interest is:
A = P X (1 + r) ^ n
A = FV: how much money you have in the future.
P = PV: initial investment
r: compound interest
n: number of year for compound interest
You invest the amount P = 200.000 in the stock market for t = 10, 20, 30 years, you invest with a compound interest rate of 10% / year, applying the formula of the amount you receive, including capital and interest are:
After 10 years, A = 200.000 X (1 + 10%) ^ 10 = 518.748 PHP!
After 20 years, A = 200.000 X (1+ 10%) ^ 20 = 1.223.181
How to maximize the power of compound interest
Start saving early
Start early now, no matter how old you are, start saving now. Because only a small amount of money and persistent investment are needed, compounding will work as a miracle to multiply your savings over the same time.
Keep regular savings principles and try not to use your deposited amount because compound interest only works when you give your deposit a chance to grow. As you can see, just saving even 3 million / month can generate more than 800 million after 20 years.
You may not see results at first, but persevere as compound interest is only visible to long-term savings.
After the analysis above, have you been impressed with the power of compound interest and savings? However, surely many of you will tell yourself: “Next year I will start saving!”.
Don’t procrastinate any more because this is a serious mistake in saving. The cost of procrastination won’t be small because even a year of delay makes a difference.
The rule of 72 in compound interest
In order to fully exploit the power of compounding interest, we cannot ignore the rule of 72 in investment.
The rule of 72 is a formula for determining when your money or investment will double at any rate.
With this rule, you only need a bank deposit with an interest rate of about 10%. So if you divide 72 by 10, the result is 7.2. So with the power of compounding and the rule of 72, after only 7.2 years your initial amount has doubled.
Interest rate = 72 ÷ double investment period.
Take an example: If you want the money in your account to double over a nine-year period, what should the bank deposit interest rate be?
The answer is 72 divided by 9, the result is 8 which means the interest rate needed to double money in 9 years is 8% / year.
This rule can also be used to find out how long it takes for the value of money to halve due to inflation. If inflation is 6%, then a certain amount will be worth half in 72 ÷ 6 = 12 years.
On a side note, the rule of 72 is only reasonable with interest rates between 6% and 10%. When dealing with interest rates beyond this range, the rule of 72 can be adjusted by adding or subtracting 1 from 72 for every 3 interest rate points diverging from 8%.
However, Rule 72 is only considered relative. But also a quick mental calculation for us to calculate interest in investment. If you need to get an exact result, you can learn more in the calculation of present value (pv), future value (FV) by compound interest and discount rate.
With knowledge of compound interest, hopefully you have understood the benefits that it will bring to your long-term investment and development.
Hopefully, through this article, Fastloans.PH has helped readers to understand what compound interest is and how to calculate compound interest for your investment activities. Good luck.