Family Finance

The Life-changing Magic of Compound Interest

June 29, 2022

When saving for a long-term goal like retirement, children’s college education fund, or home-ownership, you want to see your money grow. You’d like to see your initial investment earn attractive interest to cushion you from rising inflation and, on top of that, make you a profit. All this while you are breaking little sweat and lowering your risk exposure.

Yet not many investments afford you that luxury. But the few that do have one fascinating concept behind them: compound interest. Understanding how it works can help you save and invest better for your future.

Often referred to as man’s greatest invention, compound interest can help anyone grow wealth rapidly while avoiding the effects of inflation, increasing cost of living, and reduction in purchasing power of the Kenya Shilling.

So, what is the life-changing magic of compound interest? And how is it calculated?

This article takes a deep dive into what compound interest is, how to leverage it and make money work for you, and when compound interest can work against you.

What is Compound Interest?

Compound interest is the interest you earn on the sum of your initial principal and the interest you earned from the prior period. In simpler terms, it is earning interest on the principal plus accumulated interest.

Unlike simple interest, where interest is calculated only on the principal, compound interest sums the principal and all previously accumulated interest to create a new principal, then calculates interest based on the new principal.

If you deposited Ksh200,000 in a fixed bank account that earns you simple interest at the rate of 7% per annum, you will have Ksh214,000 at the end of the first year. Then Ksh228,000 and Ksh242,000 at the end of the second and third year, respectively.

If you saved the same amount in an account that earns you compound interest at the same interest rate annually, in 3 years, you would have Ksh245,008.60.

The Ksh3,008.60 difference between the two is the interest earned from the accumulated interest in years one and two. And if the interest were compounded monthly instead of yearly, the difference would be Ksh4,585.12. That’s the magic of compound interest.

Compound interest accelerates your interest earnings, causing your savings to grow exponentially.

Calculating Compound Interest

Compound Interest is calculated using the mathematical compound interest formula

A = P(1 + r/n)^nt

Where

A = the future value, including interest earned

P= the principal balance

r = the annual interest rate, in decimal

n = the number of times interest is compounded per time period (i.e. monthly or yearly etc.)

t = the number of time periods

Here is an example of how it works.

If you deposit Ksh50,000 in savings that account earns you compound interest at 6% per annum; how much will you have at the end of 5 year period?

Principal amount (P): 50,000

Annual rate (r): 6% (0.06)

Compounds per year (n): 1

Years (t): 5

A = 50000(1 +0.06/1)^(1*5)

A = 66,911.28

Over the period of 5 years, your savings grew by Ksh16,911.28.

Since interest can be compounded at different intervals and not just annually, the results could vary. Depending on your bank account, interest can be compounded daily, monthly, quarterly, semi-annually, etc.

How much will you have if your Ksh50,000 was compounded daily or quarterly at the same rate?

For Quarterly

Principal amount (P): 50,000

Annual rate (r): 6% (0.06)

Compounds per year (n): 4

Years (t): 5

A = 50000(1 +0.06/4)^(4*5)

A = 67,343.75

For Daily

Principal amount (P): 50,000

Annual rate (r): 6% (0.06)

Compounds per year (n): 365

Years (t): 5

A = 50000(1 +0.06/365)^(365*5)

A = 67,491.28

Notice something? The higher the number of times your interest is compounded, the more money you earn. Interest compounded quarterly earns more than interest compounded annually.

A savings account or investment that compounds your money daily is the best way to grow your capital.

Compound Interest and Retirement Planning

Nowhere is the power of compound interest more visible than when saving or investing for a long-term goal like retirement. A Ksh200,000 investment that earned you a mere Ksh4,585.12 after three years could balloon to almost Ksh1,633,000 after 30 years.

This phenomenon is what makes compound interest your best friend in retirement planning.

Starting early and adding more money to your initial capital can see you grow your wealth more.

Let’s consider two scenarios.

After learning about the benefits of early retirement planning, David, 26 years old, decided he would commit Ksh5,000 every month to his retirement fund. He opened a high-yield saving account that compounded his interest daily at 5%p.a. He started the fund with Ksh20,000 he had saved in his M-SHWARI account. David plans to retire at 66.

If David saves 5,000 every month until he retires in 40 years, he will have Ksh7,813,413.75. Over the same period, he would have contributed Ksh2,420,000, including initial capital to his fund. Meaning that he more than tripled his money.

In scenario two, David shares his idea with his 36 years old colleague Peter. A senior manager who plans to retire in 20 years. Peter decides to take David’s idea and starts his retirement fund with Ksh500,000. He will commit Ksh15,000 every month to the fund and earn the same interest as David.

At the maturity of his fund, Peter will have Ksh7,544,192.24.

Despite contributing almost double what David contributed, Peter could still not save as much as David in his retirement fund. And that is because David had more time, which allowed for more compounding and more fund growth.

Starting retirement planning when you are younger (in your 20s) and having fewer responsibilities will help you save more while investing less. Starting later will require that you save more to catch up with your retirement needs.

The Rule of 72

In compound interest, the rule of 72 refers to the formula investors use to roughly determine the number of years it will take an initial investment to double in value at a given annual interest rate.

You simply divide 72 by the fixed interest rate to determine when your investment will double.

For example, if an investment is earning you a fixed return of 9% per year, it will take roughly eight years to see your investment double. You simply divide 72 by 9.

Investments that Offer Compound Interest

Compound interest investments allow your assets to grow in value by earning interest on initial starting capital and profits. When investments grow, they compound and make you even more profit.

They’re two ways to grow investments with compound interest. In one type (like a high-interest saving account), compound interest is automatically calculated daily without you lifting a finger. In the second type of investment (like SACCOS), you must take dividends earned and reinvest them.

Here are four types of investments that harness compound interest's power to grow wealth.

High-yield Savings Account: These are a type of savings accounts that offer higher interest rates than traditional savings accounts. Interest is compounded daily, monthly, quarterly or yearly, depending on your chosen financial institution. Banks and SACCOS offer this service in Kenya.

Fixed Deposit Account: These special savings accounts let people save for a specific period and earn fixed interest rates. Unlike high-yield saving accounts, Fixed Deposit Accounts don’t allow for cash withdrawals until the maturity period is reached. The compounding interval varies depending on your issuer.

Listed Securities and Stocks: Although considered risky due to their fluctuating value, stocks can help you compound your investment. Buy shares of publicly traded companies that pay dividends, then use the dividends to buy more shares. You will increase future dividends, and if the share price rises, you realise capital gains.

Pension Funds: The National Social Security Fund (NSSF) is the country’s central retirement planning fund you can invest in to earn compound interest. The entry point is as low as Ksh200 per month, and your employer can match your contribution. If NSSF doesn’t appeal to you, they’re other available pension funds. Ensure the one you choose is fully registered by the Retirement Benefits Authority.

Compound Interest Debt

Just like you earn more interest with compound interest investment, you can pay more interest with compound interest loans—especially when the interest rates rise, and you take longer to repay the loan. When this happens, compound interest works against you.

Consider Diana; she took a five-year loan of Ksh100,000 with an interest rate of 5 percent that compounds annually. If she pays it off in three years, she’ll pay Ksh15,762.50 in interest. But if she pays off over five years, she’ll pay much more in interest: Ksh27,628.16.

Some debts that accrue compound interest include mortgages, credit cards, overdrafts, shylock loans, and mobile money app loans.

WRAPPING UP

Due to its ability to ensure exponential growth, compound interest has been hailed as the greatest way to build wealth by billionaires like Warren Buffet. And the world-famous Physicist Albert Einstein called it “the eighth wonder of the world.”

By starting early, you can exploit the power of compound interest and start building wealth. Starting with simple investments like high-interest saving accounts will help you learn how they work. And from there, you can grow.

To protect yourself from paying high compounded interest on debts, pay your debts in time and, if possible, avoid all debts that compound interest to exploit debtors.

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Farah Nurow is an experienced Content Writer who enjoys writing creative and educative articles meant to provoke readers' thoughts. He loves sunny weather and thick books. You can connect with him on LinkedIn.