Complete Guide to Compound Interest: How is it calculated?
Saving and investing are the most effective ways to retire early. In this way, we can make use of compound interest to accumulate wealth. If you want to learn more about compound interest and why it is better to get started sooner rather than later, then please read on.
Make Use of Compound Interest to Accumulate Wealth
If you only save but don’t invest, you can’t really build your wealth over time. Compared to simple interest, compounding makes your investment grow at a faster rate because on top of earning returns on the money you invest, you also earn returns on those returns over time, which is known as the snowball effect. The sooner you start saving, the easier it will be to reach your goals. In other words, you don’t have to save as much to reach your saving goals.
What is Compound interest?
With compound interests, you can not only earn returns on the initial principal you invest, but also earn returns on the accumulated interest of previous periods. Essentially, it is a cycle of earning “interest on interest” which can cause your savings to rapidly snowball.Therefore, the longer you wait to start saving and investing, the more compound interest you will miss. See below an example:
If you invest HK$1,000 monthly with an estimated annual return of 7% (the average return rate of Vanguard S&P 500 ETF <VOO>), starting from 25 years old, the estimated returns you would get are outlined below:
| Number of years of investing | Principal + Interest | Principal Amount |
|---|---|---|
| 10 years | HK$165,797.38 | HK$120,000 |
| 30 years | HK$1,133,529.44 | HK$360,000 |
| 50 years | HK$4,878,347.15 | HK$600,000 |
As you can see, starting early is much more advantageous. You can get 8 times your principal amount in 50 years!
Why is it important to start investing early?
You may be surprised to learn that the key to compound interest is not principal but time.The sooner you start saving and investing, the sooner you can enjoy the benefits of compounding. If you are early in your career, you may be under the impression that you could wait until you earn more to save and invest. It is actually the opposite. Saving now can give you a huge edge on your finances.
When you start saving actually outweighs how much you save. It is possible for your money to grow to a large sum even with a small initial investment if you start early. Conversely, even though you invest more later, you may not be able to catch up the principal & interest gained over time if you were to start sooner! See below an example for comparison:
| Age when you start investing | Returns at the age of 60 | Rate of Return |
|---|---|---|
| 25 years old | HK$106,765.81 | 106.8% |
| 40 years old | HK$38,696.84 | 38.7% |
As you can see, starting early is the key to saving faster and more. The effect is so significant that people who start later can’t simply catch up, even if you save for an additional number of years. The best scenario is for you to begin saving early and never stop until you retire, no matter if you invest monthly in stock, funds or bonds.
What can I invest in to get Compound Interest?
Invest monthly in stock or funds
Regular savings plans require you to invest monthly in blue chip stocks regardless of market performance. By investing monthly, it protects you from most of the volatility of stocks using the dollar-cost averaging strategy. It helps you to ride out the ups and downs in the long-term and you will eventually gain from the market’s upward trajectory.
Invest in low-risk investment
If you opt for only low-risk investments, you can consider investing in high-yield savings accounts, savings bonds or saving insurance. If you start early, you can also enjoy a drastic snowballing effect. Don’t forget to put your interest to further your principal to achieve the snowball effect.
Invest in REITs and/or ETFs
If you are a beginner, you don’t have to buy stocks in individual companies. Instead, many ETFs track big tech companies, which can diversify your stock holdings. There are lots of FAANG ETFs on the US market such as:
- Invesco QQQ (QQQ) on Nasdaq
- iShares Russell 1000 Growth ETF (IWF) on NYSE Arca
- Vanguard Growth ETF (VUG) on NYSE Arca
- iShares S&P 500 Growth ETF (IVW) on NYSE Arca
- Schwab U.U. Large-Cap Growth ETF (SCHG) on NYSE Arca.
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FAQ
What is compound interest hailed as the 8th wonder of the world？
- Different from simple interest, compound interest is essentially a cycle of earning “interest on interest” which can cause your savings to rapidly snowball.
Why do some people fail to use compound interest to their favour?
- It is mostly because they fall into the trap of selling their investment too soon when they see the market goes down.
How can I make use of the effect of compound interest?
- There are many ways including investing monthly in stocks, funds, high-yield saving accounts, bonds or saving insurance. The key is to start early and be consistent.