If you think compound interest and investing are confusing, you are not alone. In this blog, I will break down the concept of compound interest as the most straightforward math. It will help you understand why it is better to start investing early. By using graphs, calculations and formulas, I hope it will be a pleasant experience.
Basically, there are 2 types of interest: Simple and Compound.
Simple interest
It is a set of the percentage of the principal every year. To calculate simple interest:
Simple interest = interest rate x principle balance
For example, I put $10,000 in the savings account with an annual interest rate of 4%. At the end of my first year, I will gain $400 (0.04 x $10,000). There will be a total of $10,400 in my savings account. In the second year, you will earn another $400, and so forth.
Simple interest is simple and not practical because it only estimate the amount collected in one fix period.
On the other hands, compound interest is “interest on interest.” Compound interest increases the principle. The longer the time available for the principle to grow, the higher the return. It is the standard of finance, and it is the solid foundation for success for many investors.
Related: Retirement Calculation formula
Similar to the above example, with 4% annual interest on a $10,000 investment, the return does not show differences at first. However, in the second year, the 4% interest is calculated on the new balance which now is $10,400. This will generate a payment of (0.04 x $10,400) = $416. A $16 increase from the previous might not be a lot, but you will be surprised how quickly it can add up.
At 4% interest, the $10,000 investment will turn into $39,460.89 after 35 years. Compound interest will be even more powerful because the investment will be over $70,000 after 50 years. Let’s take a look at this graph:
Here is the breakdown of the investment over every ten years period:
Not everyone has 50 years to grow the investment. This chart is meant to show how powerful compound interest can make on a stake of as little as $10,000. Imagine what would happen if you start with a higher principle and continuously make more contributions to the account.
There are many ways to take advantage of compound interest. Below are a few ideas:
Bank account
Not all banks have the same interest rate. The chart below shows the low balance saving account interest rate this year across different banks.
APY stands for Annual Percentage Rate, and it is the same as the interest rate. For instance, I put $10,000 into Bank of America Saving account with the 0.01% interest rate.
If I don’t make any additional contribution to the principal over 50 years, the $10,000 only grow a tiny bit to $10,050.12. A difference if $50.12 over 50 years is not worth it to me. The rule of compound interest still applies in this case, but the growth is insignificant due to such a small interest rate. In my opinion, leaving money in your bank account is never a good idea unless you want to save hard cash.
Bonds
Zero-Coupon bonds or accrual bonds have compound interest, but regular bonds do not. Let’s quickly go over some definitions:
a. Par value: The money you use to buy the bond.
b. Maturity value: The return of your original investment
c. Maturity date: the date at which you get the return of your original investment.
d. The bond return: The interest rate associated with the bond
e. Coupons: the interest payments
Regular bonds offer simple interest. For example, if you bought a $1,000 bond with a 4% yield:
· If bonds pay an annual coupon, you will get $40 during the year ($1,000 x 0.04)
· If bonds pay a semi-annual coupon, you will get $20 every six months which equals to a total of $40 a year.
Zero coupons function a little different. As the name suggests, it is not obligated to make any coupon during the term of the bonds, but an investor can get it at a very low and affordable price compared to the face value. For instance, a 20-years term zero coupons bonds with a face amount of $30,000 and a 4% interest rate are offered at a discount price of $7,000. 20 years from now, the investor will receive $30,000. The difference of $23,000 ($30,000-$7,000) is the interest that compound over the years until the bond matures.
Related: Roth vs. Traditional IRA
Stocks
I am using S&P500 as a prime example in this case study because it is the simplest way of investment that I recommend.
“The Standard & Poor’s 500® (S&P 500®) for the 10 years ending December 31st 2016, had an annual compounded rate of return of 6.6%, including reinvestment of dividends. From January 1, 1970 to December 31st 2016, the average annual compounded rate of return for the S&P 500®, including reinvestment of dividends, was approximately 10.3%” source:
www.standardandpoors.com
Let’s say our initial investment to the S&P500 is $25,000. With a steady return rate of 6%, I will contribute $600 every week for the next 30 years.
There always risks involve but we assume that everything will go smoothly.
I hope you see the power of compound interest and take advantage of it. Cheers.
I am thankful for the resources obtained from:
Investopidia.com, Budgeting.thenest.com, Fool.com, Bankrate.com, Investor.gov
