Effects of compounding interest

Compound interest means interest earned on top of previous interest. The interest you earn on a principal amount is reinvested as part of the principal amount so that in the next cycle, you’re not earning interest just on the original principal amount but the combination of the principal amount and the interest earned so far.

Whether for the good or the bad, compound interest affects us all by thousands of dollars. Credit card debt, retirement accounts, personal loans, investments, and so on – compound interest is everywhere and changing our finances as we speak. You need to get a good grip on how compound interest is affecting your finances and whether you are in net gain or net loss.

Compounding interest is a not a difficult concept to grasp. But still, more often than not, you will find people confused by how it works. In this piece, we’re going to troubleshoot all your queries as well as explain how compound interest works in detail.

Good financial management comes from the understanding of the basics – so that’s where we will start.

What is compound interest

Compound interest is a type of interest gain (or loss – depending on whether we’re talking about investments or loans). For simplicity, let’s assume we’re talking about gaining compound interest on an investment and not losing it on a loan or credit.

When you earn an interest on your principal amount, this interest amount is added to your principal amount. The next iteration of interest will be processed on this combined sum and not the original principal amount.

This can help you accelerate wealth creation as it has a compounding effect. That’s also why it’s called compound interest.

When applied over a long period and when the amount of money is substantial, compound interest can easily double your wealth if you’re investing or decimate your wealth if you have a compound interest loan.

Example of compound interest

Let’s say you have an investment of S$1,000. The interest you gain on it is 10% per month. Here’s an example calculation that will better illustrate the point:

  1. You gain 10% interest on the S$1,000 principal amount in the first month – which is S$100.
  2. This S$100 interest is now added to the principal amount. Now, your principal amount is S$1,100.
  3. In the next month, interest will be calculated on S$1,100 and not S$1,000. Meaning the second month, you end up with S$110 more – S$1210.

Let’s compare this with normal interest. If you keep gaining 10% on the principal amount each month on your investment (normal interest), you will keep earning S$100 on your S$1,000 monthly. This will be fixed forever.

By the second month, you would have had a total of S$1,200 instead of S$1,210. Might not sound like a big gain, but let’s calculate a more realistic sum in a more realistic time period.

Principal amount: S$8,000 invested for 24 months at 10% interest.

Normal interest: S$8,000 principal amount + S$19,200 = S$27,200.

Compound interest: S$8,000 principal amount + S$70,797 = S$78,797.86

Quite the difference, right?

Basically, the larger the amount, the more interest it will generate. And the more interest you keep adding to the principal amount, the more total interest you will end up with at the end of the tenor.

Compound interest on earnings vs. compound interest on loans and credit

Compound interest is great if you’re investing but it’s terrible if it’s working against you. Loans don’t usually have a compounding interest but various forms of credit do.

For example, credit cards work on daily compound interest. In this case, the bank is essentially multiplying each day’s average balance by the daily periodic rate of the account – and then adding it to the daily balance of the next day. The cycle repeats.

In other words, all unpaid dues are the principal amount. An interest is charged on it daily. This interest combines with the unpaid dues. And the next day, your new interest is calculated on this combined sum.

Your debt can easily snowball out of control if not managed periodically and carefully if compound interest is in play.

What is the Rule of 72?

The Rule of 72 allows you to determine how long will it take to double your money with compounding interest.

The formula is simple. Just divide 72 by the interest rate. Let’s assume the interest rate is 4% per annum. 72/4 = 18. Compounding interest will double your money in 18 years at a 4% interest rate.

Compound interest management for debts

If you are being charged a compound interest on your debt (for example if you are using a credit card with overdue payments) then you should immediately try to pay your dues and build a strategy to get out of the debt.

Compound interest debt is a shortcut to crippling debt that will never end if left unchecked.

The bottom line

Two things you need to keep in mind even if you don’t understand all the maths:

  • Simple interest is great for debts. Compound interest is disastrous for debt.
  • Compound interest is amazing for investments. Simple interest is okay for investments.

With that information under your belt, we hope you can make better financial decisions from now on.

Here’s a quick comparison between simple and compound interest:

So, where do you go from here? The first step is to review all your finances. All your accounts, all your investments, assets, loans, debts, credit. Essentially all ins and outs. See which of these are working on a compound interest basis and which are on a simple interest basis.

Once you have reviewed your current financial standing you’d be able to determine whether you will be in crippling debt 10 years down the line or much richer than you are no.