With an annual interest rate of 7.5%, you can double your money every ~10 years, guaranteed!
How to double your money guaranteed? The answer is compound interest. Compound interest is one of the most important concepts in investing, so please read through this article. If you don’t trust me, maybe you can trust one of the smartest people in the world, Albert Einstein.
How does compound interest work?
Compound interest is when the interest you earn is reinvested, thus earning even more interest. With compound interest, you do not just earn interest on your initial principle but also on the interest earned on it. You just have to reinvest the interest back into your principal balance.
To illustrate how this works, let us start with a simple example.
Let us say you have $1000 invested and earning 7.5% interest per year.
- By the end of year 1, you will have $1000 + 7.5%*$1000 = $1075.
- By the end of year 2, you will have $1075 + 7.5%*$1075 = $1155.63.
- Let us continue this until the end of year 10:
| Year | Initial balance ($) | Interest earned this year ($) | End-of-year balance ($) |
|---|---|---|---|
| 1 | 1000 | 75 | 1075 |
| 2 | 1075 | 80.63 | 1155.63 |
| 3 | 1155.63 | 86.67 | 1242.3 |
| 4 | 1242.3 | 93.17 | 1335.47 |
| 5 | 1335.47 | 100.16 | 1435.63 |
| 6 | 1435.63 | 107.67 | 1543.3 |
| 7 | 1543.3 | 115.75 | 1659.05 |
| 8 | 1659.05 | 124.43 | 1783.48 |
| 9 | 1783.48 | 133.76 | 1917.24 |
| 10 | 1917.24 | 143.79 | 2061.03 |
Congratulations, you just doubled your money!
This is the magic of compounding interest.
Interest earned from interest will create a snowball effect if reinvested over a long period.
The legendary investor, Warren Buffet, grows his investment throughout his investing career by using this principle of compound interest.
Why should you care?
Compound interest helps accelerate the growth of your wealth over time. As illustrated in the example above, you can double your money:
- Every 10 years if you earn on average 7.5% per year.
- Every 20 years if you earn on average 3.75% per year.
- Every 5 years if you earn on average 15% per year.
- The formula is to divide 72 by your annual interest rate. That is how many years it takes to double your money.
On the flip side, if you are in debt, the same principle of compound interest can cause your debt to grow faster over time. Pay your debt as soon as possible, especially if the interest rate is high. In this article, we will not go in-depth into this debt spiral aspect, but we will focus more on learning how compound interest can grow our wealth over time.
What does this mean for me?
Let me introduce you to the 30-year-old Alice:
Alice: “Eh… I’m still young, super long way from retirement, why bother now?”
Well, those are the famous last words we often hear. After 5, 10, 20 years, Alice still says the same thing, and she has been missing this magic of compound interest. You don’t want to be like Alice, do you? So keep on reading below.
As you can observe from our example:
- The longer the duration of your investment, the more your investment will grow.
- The higher the interest rate and the more the compounding frequency, the faster your investment will grow.
- The initial balance does not matter. Thus, you can start today with a small balance while adding to it over time.
The chart above illustrates how various investment durations affect the growth of your investment over time.
Looking at the chart, it is pretty evident that you should start investing as early as possible. We recommend that you start investing from your first paycheck. The earlier you start contributing to your investment, the more you will have when you retire. If you start investing at age 25, you will have 4x more money at retirement compared to those starting to invest at age 45.
This chart illustrates how different interest rates affect the growth of your investment over time.
From the illustration above, it is clear that we want to watch the growth rate like a ‘hawk’ because it significantly impacts our wealth in the long run. But at the same time, you do not want to take excessive risk chasing high returns while risking your initial capital.
If you have the cash you can spare for investing, you may want to start as early as possible. You will also want to find where you can earn more interest on your money.
Now that you understand how compound interest affects your wealth over time, you can start planning for your financial future. The time to take action on your part is now. It is never too late, and you can still grow your money with this magic of compound interest starting today.
Alice: “Okay okay, I’m sold, so how should I start investing?”
Well, that is good news if Alice finally wants to start investing.
Our goal here is to help you gain enough knowledge so that you can make informed decisions about your financial future. Follow us, and let us learn together to achieve our financial freedom.
