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Whether it is the interest on your home loan or the yields on your various investments, interest rates play a crucial role when it comes to your money. And while we often associate these with their ability to drain our bank account most especially when it comes to loans, one type of interest – compound interest – can help you earn a higher return on your savings and investments. One of the most important concepts to understand when managing your finances and the basis of everything ranging from your personal savings plan to the long-term growth of the stock market, compound interest can significantly boost investment returns over the long term, so the sooner you start to save, the more you will earn. Here we analyse the power of compounding and how it can help you grow your savings.
The first thing that may cross your mind when thinking of interest is debt, however, interest can at times work to your favour, most especially when this is earned on the money you have either saved or invested. As a result, compound interest is interest earned on money that was previously earned as interest, in addition to the initial principal. Think of it as a cycle of earning interest on interest and it is an excellent process of growing your money, so much so that it will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated on the principal amount alone. In this manner, your balance does not just grow, but it does so at an increasing rate, marking what is known as exponential growth. An important element when it comes to calculating the compound interest is the number of compounding periods which makes a significant difference. The frequency by which the accumulated interest is paid out or capitalised could be yearly, half yearly, quarterly or monthly, while at times it may also be daily. As a general rule, the higher the number of compounding periods, the greater the amount of compound interest. Compound interest’s formula is calculated by multiplying the initial principal amount by one, plus the annual interest rate raised to the number of compound periods minus one. An easy way of calculating this is to use our Compound Interest Calculator and give various scenarios a go.
As stated above, compounding takes place when interest is paid repeatedly, this is why the frequency of compounding is so crucial. However, there are other factors:
You can make the most of compound interest if, for instance, you invest in a Bond or an Income Fund that allows an investor to accumulate interest year on year. Let us take investing in a Bond as an example: An investor invests €10,000 in a bond that pays 7% interest per annum. The Bond would pay interest of € 700 on the first year, therefore the balance would be €10,700 at the end of the first year. On the second year the interest of 7% would be calculated on € 10,700 and therefore the interest received would be €749. In year two the investor does not need to add anything to his savings, although he may choose to do so to increase the multiplier effect. On the third year the interest of 7% would be calculated on €11,449 (€10,700 + €749) and so the interest received would be €801.43. This process would continue until the Bond is either redeemed or is sold. In this example an investor would almost double his money in 10 years without adding any extra capital. For a clearer picture of the above example, have a look at the table below:
Let’s consider two investors: Investor A Starting from the age of 25, Investor A puts € 2,000 per year into fixed income, like Bonds or an Income Accumulator Fund for 10 years until he is 35. At 35, he stops and does not put any more money into his investment portfolio and lets his investment work alone. Investor A then leaves his investments to grow until he hits age 65. He earns an average annual return of 8% and when he looks at his account 30 years later, he has €314,870. Investor B Investor B does not save anything until he is 35, at which age he starts investing €2,000 per year. He keeps this up for the next 30 years until he reaches 65. Investor B earns an average annual return of 8% too but he ends up with € 244,691 at the age of 65. As a result:
This means that Investor A is now worth 28% more than the Investor B even though Investor A only invested a third of the amount.
There are other elements to consider if you want to ensure that compounding works to your advantage.
Pay off your debts as soon as possible: if you have credit card debt, paying the bare minimum can cost you since you will hardly be making a dent in the interest charges, while in actual fact your balance could grow. So pay off debts as quickly as possible and if you can, pay extra. Watch out for the annual percentage yield (APY): the APY is the real rate of return earned on a savings deposit or an investment and it’s important to look into this since it takes into account the effect of compounding and can provide a true annual rate.
Starting to set something aside at an early age will give your investments time to grow and produce a compound interest multiplier effect that will help you in the later years. One of Malta’s largest independent financial services group and a founding member of the Malta Stock Exchange, CC pioneered the local financial services industry in 1972. Since then the Group has established itself as a 360-degree financial planner for investments, pensions and life insurance, while it offers a range of investment products that can help you make the most of compound interest. Get in touch with one of our financial advisors today to get started.
Disclaimer
The information provided on this website is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Similarly, any views or opinions expressed on this website are not intended and should not be construed as being investment, tax or legal advice or recommendations. Investment advice should always be based on the particular circumstances of the person to whom it is directed, which circumstances have not been taken into consideration by the persons expressing the views or opinions appearing on this website. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views, or opinions appearing on this website. You should always take professional investment advice in connection with, or independently research and verify, any information that you find or views or opinions which you read on our website and wish to rely upon, whether for the purpose of making an investment decision or otherwise. CC does not accept liability for losses suffered by persons as a result of information, views, or opinions appearing on this website.
Calamatta Cuschieri Investment Services Ltd is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act.
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