Saturday, May 30, 2009

Why Compound Interest Is So Powerful?

In fact, it is nothing that really powerful about compound interest even though Albert Einstein has quoted the following:

“Compound Interest is the greatest force in the world”
Einstein, are you sure about that? The compound interest itself is not powerful but it is the human mind or emotion to make it the powerful one. If I were to say, what the greatest force in the world is, I will say it is “Human Mind” – our mind. Why the compound interest can become so powerful is due to the fact that:
“We do not know how it REALLY works or we simply IGNORE it!”

How Compound Interest Works?

Compound interest simply means to REINVEST your investment return into your total investment amount. Total investment amount is called PRINCIPAL in personal finance. Let’s say I invest $100 with 10% return. The investment return is $10 and I used back this money to reinvest, so my total investment or new principal value is now becoming $110. Second year, I reinvest at $121 (new principal amount). In following years, my investment return grows exponentially…

Note: Compound interest is also applicable to loan or mortgage interest. E.g. Your loan principal amount will grow exponentially if you don’t reduce your loan principal.


The Key is Exponential Growth

Your principal grows exponentially with the compound interest, that is how the magic works and that’s why we like to say it is powerful. Looks at the chart below:


In 7 years, I can X2 my money - ~$200 (see also Rule of 72). In 12 years, I can X3 my money - ~$300. In 15 years, I can X4 my money - ~$400. In 17 years, I can X5 my money = ~$500. In 19 years, I can X6 my money - $600. As you can see, the longer term I have the, shorter the period that I need to double-up my money. Can you see this MAGIC?

This is usually how those insurance agents use this magic to convince or trick you to buy their insurance especially for those non-term insurance policy.

In personal finance, everything is about compound interest whether you have car loan, housing loan, credit card loan, invest in stocks, unit trust, fixed deposit or the most important element in personal finance– inflation rate

Summary
Compound interest is really that powerful by itself or we don’t understand it that makes it powerful or we ignore it that makes it powerful? What do you think?

7 Comments:

Alvin Lim said...

Compound interest is as powerful as we think it it - or better, as powerful as how we want it to be. If you don't know how to use it, it's not powerful at all.

And with the current 2% FD...erm...compound interest for the investor is pretty difficult to achieve ;)

Also, those insurance and mutual fund agents always use the theory of compounded interest to attract people who donno what it is. They will show u the amount of money you get in 30 years, by just investing RM 100. What they didn't show you is that, our inflation rate can actually make that final amount not so significant at all.

Relax said...

compound interest will make you super rich if you can live 1000 years and wait for that long.

ChampDog said...

@Alvin
Good point! Things will only become powerful only if we know how to apply them.

I don't think people should treat FD as an investment. FD is always a saving for me.

Yes, that is the thing you minus out the inflation, it probably won't be a big deal. But still, many are still attracted by the huge amount of return.

@Relax
1000 years? Are you trying to say that we will never get rich using the compound interest?

Relax said...

I mean it takes long time to become SUPER rich. That kind of filty billionaire rich.

If your goal is just mediocre financial freedom, it takes only a few years and some "luck". Thanks to compound interest.

imDavidLee said...

so, compound interest can bring advantages and oso disadvantages..it's better to think twice when applying loan to buy anything like car ,home...

ChampDog said...

@Relax
Yes, that's why super duper rich people do not really rely on compound interest. Compound interest is for average people to get rich slowly IMO.

@Dave
Yes, compound interest on loan could be really scary. Inflation is also one of them...

Thomas Watson said...

I cannot agree more here. Great article.


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