The Beauty and Beast of Compound Interest
I am a big fairy tale fan! I love all the Disney princess movies and in my weekly daydreams, I'm living a fairy tale life and this week was no different.
This week I was thinking about Beauty and the Beast, it is one of my favourite Disney movies plus it is set in France!
I was thinking about how two-faced compound interest can be and realised it could be like a beauty "Belle" to some people and at the same time a "beast" to others. All because of "compounding".
But what I love most about fairytales is the happily ever after at the end. I truly believe every ugly beast (e.g. debt) can turn into a Prince Charming if you have a plan!
For many years, banks and financial credit companies have used compounding to get rich, and now is the time to level up. My goal is to show you how to use compound interest to your benefit and beat the banks.
By the end of this post, I hope you
Understand how compound interest works
Why in the long run investing is better than saving
Why you lose money if you leave your long term savings sitting in cash in your bank account
Why you should pay off any high-interest loans
What is Compound Interest?
By far the most important two words when it comes to investing in the stock market or getting a loan are the words “compound interest”. It is the reason why many people today are rich and why many more are in huge unwanted debt. But what does it really mean? And is it that important?
Compound interest means “interest on interest”. It is the way to build wealth from little cash based on the interest rate and time. We can see the effect of compound interest when we earn interest on our savings and we reinvest that interest earned in addition to the initial amount invested. As we keep reinvesting the interest earned, our money will continue to grow. It will eventually double and continue growing. In other words, as long as you keep investing, your money will be your employee going to work and bringing you daily profits.
For example (ignoring tax and interest rate fluctuations) if you deposit £10,000 into an investment account which paid 8% interest per year.
After year 1 you would earn £800 payment in interest. At the start of year 2, you would now have £10800 as your new balance. A further 8% interest will give you a payment of £864. And by year 3 you will be earning 8% on £11,664 (10800+864).
“Most great fortunes are built slowly. They are based on the principle of compound interest, what Albert Einstein called, “The greatest power in the universe.””
3 things that Bring out the Beauty of Compound Interest
Frequency of compounding
The frequency of compounding on your investment account i.e. how often the interest on your account is calculated has an effect on how fast your money grows. The more frequently the compounding the faster your money grows. If your money compounds annually, it means that your interest is calculated once a year. If your money compounds monthly it means your interest will be calculated 12 times a year, and in some cases, money compounds daily, in these cases your interest will be calculated on a daily basis. we used annual compounding -- meaning that interest is calculated once per year. In practice, compound interest is often calculated more frequently. Common compounding intervals are quarterly, monthly, and daily, but there are many other possible intervals that can be used.
The compounding frequency makes a difference -- specifically, more frequent compounding leads to faster growth. For example, here is the growth of £10,000 at 8% interest compounded at several different frequencies.
2. Rate of return
Here is a perfect example to illustrate the beauty of compound interest. It is adapted from the book Making Money made simple by Noel Whittaker.
If you saved £10k only and invested it at 8 % compounding each year it would build up to 46,610 in 20 years. However if you saved the same £10k and invested it for the same 20 years, but this time at a new rate of 16% which is double the initial rate. Although we would logically assume that by doubling the interest rate, we would double the resulting amount, however, because of the beauty of compound interest, we would more than quadruple our potential payout to £194,607.
This example is not to encourage you to look for a 16% rate for your investment. It is important to remember that stock market investment rates can go up or down. But it tends to stabilise over an average when you leave your money invested for a long time. This post is for information purposes only and should not serve as professional financial advice.
3. Time
When it comes to compound interest, time is your best ally. Because with time on your side you can very easily build wealth from little.
“Time is your friend; impulse is your enemy”
Imagine again you invest £10k at 8% for 20 years and you get a return of £46,610. Keeping it invested longer for a further 5 years to 25 years will increase your return by 47% (that is almost 50% increase) to £68,484!
This brings me to...
The rule of 72
This is a simple calculation of how long it will take for any amount of money (investments, savings or debt) to double. If you divide 72 by your expected rate of return it will give you the time it will take for the money to double.
Let’s look at some examples to better explain the Rule of 72
Investing rates
If I invest £10k at a rate of 8%, it will take nine years (i.e. 72/8=9) for your money to double to £20k, and a further 9 years for your £20k to double again to £40k given the rate remains the same.
Savings rate
If I leave my £10k as cash in my savings account at a rate of 0.05% (which is my actual current savings rate it will take 1440 years!!!! (i.e.72/0.05=1440) for my money to double to £20k.
Inflation rate
Current UK inflation is around 2.44%, so leaving my 10k as cash will mean that in 29.5 years (72/2.44), the purchasing power of my savings will be down by half to £5k. This is because inflation has a negative effect on cash and reduces the value of your money. I will still have 10k in my bank account but money is only worth what it can pay for. And in 29.5 years at a year on year inflation of 2.44%, the purchasing power of my £10k in the bank would have reduced by 50%.
This is important to note if you plan to do long term savings e.g. towards retirement in a low-interest bank account (an account giving you less interest than the rate of inflation).
I only learn most of this when I was 31, and I was filled with mixed emotions. Irritation for being taught earlier and gratitude for finding out now. It never too late to learn something new.
The ugly side of Compound Interest
Compound Interest is neutral that means anyone can use it. As an investor, you can use it to grow your money significantly. In the same way, creditors can use it to grow the interest you pay them on any loan significantly.
You want to be the one getting paid more compound interest than you pay out. So try to pay off any high-interest debt especially any above 5%-10% interest. This is because the stock market interest rates average is around 10% (though it can go up or down).
“Mathematically, debts grow exponentially at compound interest. Banks recycle the interest into new loans, so debts grow exponentially, faster than the economy can afford to pay.”
3 things that bring out the Beast in Compound Interest
1.Credit Card APR
So if you owe £10k on a credit card at 28% it will take only 2 Years! (i.e. 72/28 =2) for your £10k debt to grow to £20k (assuming you don’t pay any off). This is why it's important to pay any high-interest debt as quickly as you can.
2. Mortgage debt
If you have taken out a loan for a property for £100k at 3% fixed interest rate, it will take 24 years (i.e. 72/3= 24) for your debt to double to £200k if you don’t pay any of it off in between.
3. Personal loans
All bank loans, car loans, payday loans, and loan, in general, operate by this rule. That is depending on the interest rate and time it takes to pay off the loan. It will start compounding by small amounts at first then drastically grow to a huge debt beast if left unchecked for some time. You can use the “rule of 72” calculation to figure out how long it will take for any debt to double.
But every ugly beast can turn into a Prince Charming if you have a smart repayment plan!