Recently updated on: September 27, 2023
Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn't pay it. That is according to Albert Einstein.
Though some argue that this quote may have been mistakenly attributed, it is still crucial that you understand what it means and how to make compound interest work for you and never against you.
You may have heard about compound interest in your lifetime. You may even have solved it in your business math or economics subject.
However, have you ever thought about the power of compound interest and how it can positively or negatively affect your personal finances?
This post will teach you why compound interest is a double-edged sword.
Table of Contents
What Is Interest?
Before we understand what compound interest is, we first need to understand what interest is.
Interest is the amount paid to you for lending money to a person or institution, like a bank, or the money you have to pay on top of the initial amount if you borrow.
This means that interest may be advantageous or disadvantageous, depending on where you stand. Are you the lender or the borrower? And how much is the interest rate?
Suppose you save your money in financial institutions like traditional or digital banks. In that case, you may have noticed that they pay you a certain amount after a certain period of time. That amount is the interest.
For example, you saved P10,000 in a high-interest digital bank offering to pay you a 5% interest rate yearly. By the end of the year, your deposit will earn P500 in interest on top of the money you saved (minus the deducted tax for the government, of course).
On the other hand, an example of the disadvantageous interest and predatory type of lending is the "5-6" lending from loan sharks, where you will have to pay 20% more from the borrowed amount.
For instance, you borrowed P5,000 from a loan shark. When you repay it, you will also have to pay an additional P1,000 interest on top of the P5,000, making your total debt P6,000. This is dangerous and unethical and feeds off the immediate need of the borrower.
Based on the two examples, the latter is taking more money from you, while the prior is paying you more.
So, which one do you like?
This may appear that saving money in a high-interest bank is the obvious answer, but unfortunately, more people are choosing to pay high interest because they need cash immediately to finance their needs, unsustainable lifestyle, or for other reasons.
What Is Compound Interest?
Now that you understand what interest means let us dive further into compound interest.
Compound interest is when the interest you earned from your initial deposit or investment gets reinvested. In effect, your balance grows higher and earns more interest.
You earn interest not just in the initial or principal balance through compound interest. The interest that you already received also earns interest.
So if you continuously add the interest of interest to your principal amount, you will notice that it is growing faster and larger as time passes.
Interest can be compounded into different intervals depending on where it is placed, like annually, monthly, or even daily.
Another important reminder to compound interest is the time factor, which means that the longer it is invested, the higher interest it will earn.
Like what Charlie Munger said, the first rule of compounding is never to interrupt it unnecessarily.
Here's an example. For the first year, you only earn the initial interest from your principal amount. In the second year, your new starting point will be your initial principal plus the interest you made in your first year.
This means that you will earn higher interest in your second year than your first year because the interest you made in your first year will now also earn interest. This will continuously add up until you withdraw your deposits.
For instance, your initial deposit is P10,000 with a 5% annual compounding interest. You decided to keep it in your high-interest savings bank for five years and will also not add more money to your initial deposit. Here is what will happen.
Year 0 - P10,000.00 (Initial Deposit/Principal Amount)
Year 1 - P10,000.00 * 1.05 = P10,500.00
Year 2 - P10,500.00 * 1.05 = P11,025.00
Year 3 - P11,025.00 * 1.05 = P11,576.25
Year 4 - P11,576.25 * 1.05 = P12,155.06
Year 5 - P12,155.06 * 1.05 = P12,762.82
In five years, your P10,000 initial deposit earned P2,762.82 or 27.62%. It may look small initially, but if you increase your principal monthly or annually, your deposit will grow even more significantly.
How Can Compound Interest Work Against You?
Based on the previous example, compound interest may look great. However, this will only work in your favor if you're the one lending money to institutions like the bank. But if you're the one borrowing money, it will be another story.
Since compound interest is an interest that earns interest, this means that if you're a borrower, and haven't paid your debt, then compound interest will put you into deeper debt.
Let's look at one of the more common types of consumer debt, credit card debt. We will use the maximum annual interest rate of 24% per annum based on the BSP Circular 1098, series of 2020, in our calculations.
For example, you have a credit card debt of P10,000 and forgot to pay it for five years. This is what will happen to your debt.
Year 0 - P10,000.00 (Principal)
Year 1 - P10,000.00 * 1.24 = P12,400.00
Year 2 - P12,400.00 * 1.24 = P15,376.00
Year 3 - P15,376.00 * 1.24 = P19,066.24
Year 4 - P19,066.24 * 1.24 = P23,642.14
Year 5 - P23,642.14 * 1.24 = P29,316.25
In just five years, your P10,000 credit card debt ballooned to almost triple its original amount into P29,316.25.
No wonder why a lot of people that have credit card debt problems can't seem to find a way out of it. So, as a general rule, you need to pay your credit card debt as soon as the bill arrives to avoid paying interest.
For more information about properly using a credit card, you may read my earlier post here.
What is the Rule of 72?
Another essential concept in compound interest is the Rule of 72.
The Rule of 72 is a simplified formula to determine how long it will take for an investment to double in value depending on its interest rate or what interest rate you should put your money in so it will double based on your target number of years.
For the first scenario, if you want to know how long it will take for your money to double based on your interest rate, divide 72 by the interest rate of your investment, but remove the percent sign (%).
For example, if you plan to put your money in a high-interest savings account paying 6% per annum, how long will it take before it doubles?
- Number of Years = 72 / 6 (%) = 12 years
This means that it will take 12 years before your savings double.
For the second scenario, if you want to know what interest rate you need to invest in so that your money will double in ten years, divide 72 by the number of years.
- Interest Rate = 72 / 10 (years) = 7.2% interest rate
This means you must invest your money in an investment vehicle that regularly pays at least a 7.2% interest rate.
Please note that this is an oversimplified formula only intended as an initial assessment.
Many variables can change that will prove this formula as inconsistent or not applicable, like adding more to your investment every month, changes in the interest rate of your investment vehicle, and more.
Compound interest is a double-edged sword. It can either work in your favor or against you, so you must be careful.
If used properly, compound interest will allow you more financial freedom. If misused, it will dig you into a debt hole that will be a financial prison.
Always remember that there are many financial instruments that you can use to your advantage, and there are also many financial traps and scams waiting for your to fall into their pit, so practice due diligence.