Compound interest and financial planning: let your savings snowball!

Described as the eighth wonder of the world by Albert Einstein, compound interest is a powerful force that you can harness to your benefit. Conversely, it can trap you in a spiral of debt. Forewarned is forearmed so find out just how it works and use it to your advantage!

What is compound interest?

Compound interest is incredible. Given enough time, it can turn even relatively small savings into much larger sums of money.

To put it very simply, compound interest is interest on interest. Which makes it free money! Here’s how it works.

When you save, the initial sum you invest is known as the principal. This principal earns interest. And the interest earned on the principal also accrues interest. This makes initial savings deposits grow at a much faster rate.

But beware! Einstein also said of compound interest ‘He who understands it, earns it … he who doesn’t … pays it.’ Interest payable on a loan accrues in exactly the same way but in that scenario, it is working against, rather than for you. This is how people get trapped in a spiral of debt. And the reason why loan companies are making obscene amounts of money.

Compound interest lies at the core of every investment choice, from individual savings strategies to the world’s biggest pension funds. It’s the reason why you should avoid unsecured debt and establish a savings plan to reach your financial goals. And if you want a comfortable retirement, it’s critical to make one of those goals a healthy pension pot.

Compound interest: the snowball effect

When you begin making a snowball you start with a tiny amount of snow in your hand. As you roll it in the snow, the surface area of the snowball gets bigger and bigger so that each roll accumulates more and more snow. This is the perfect analogy for compound interest.

Let’s take a look at the snowball effect of compounding with some concrete figures.

At the beginning of the year, you invest $1,000 and earn 10% interest.

By the end of the year, you have $1,100.

In year 2, you earn 10% on both the principal of $1,000 and the $100 interest earned over the course of year 1.

By the end of year two, you have $1,210.

Year 3, this rises to £1,331 and by the end of year five, your $1,000 investment has grown by over 50% to $1,610.51.

That’s $610,51 of free money in just five years.

Obviously, this is a simplified example that does not consider the effect of inflation on the saved amount. It does, however, illustrate the point that over the course of a career of 40 years or more, small amounts of money invested sensibly can add up to a significant sum.

Compound interest over the long-term

To benefit from compound interest, you need three key ingredients:

Investment + Interest + Time

The longer your money is invested, the more the compound interest will accumulate.

Let’s say you invest a principal sum of $1,000 into your retirement fund. You also decide to allocate $100 per month of your income to the same fund. And you do this throughout your 40-year career.

Your total investment over the 40 years works out at $49,000.

But with 10% interest (optimistic but achievable), compound interest turns your $49,000 investment into a pension pot of $576,370!!

Here’s the graph illustrating the snowball effect.

What it’s important to notice is that the magic really happens at the end of the investment period. And that’s why you need to start investing in a pension as early as possible in your career.

You can use a compound calculator such as this one to play around with figures relevant to your own personal situation.

Benefit from compound interest and maximise your return

Whatever your age, if you aren’t already putting money aside for your retirement, now is the time to start. And of course, how that money is invested is extremely important. You will need to balance maximising return with your tolerance to risk.

The good news for expatriates in Asia is that you have a wealth of investment options to choose from. An Infinity adviser can assess your risk tolerance and talk you through the pros and cons of the different investment options available to you. This will empower you to make the right investment decisions to secure a comfortable retirement.