The effect of compounding can help you grow your wealth faster, and is the best way to work towards your retirement goals.
If you’re fuzzy on the difference between interest and investment returns, here’s a primer on how it all works, so you can project when you’ll reach your goals more accurately.
What is compounding interest
Compound interest refers to interest that you will earn on your original deposit and on the interest that your money earns over time. This form of interest applies to both deposits and loans.
Bank savings accounts work on compounding interest. To help visualise this, here’s how simple interest and compounding interest work over 60 days.
Example:
(Based on a starting balance of $20,000)
| Period | Compounding interest | Simple interest |
| Interest rate: 1%p.a. compounded monthly | Interest rate: 1% p.a. | |
| In the first 30 days | Interest earned: $20,000 x 1% x 30/365days =$16.43 Total balance: $20,000 + $16.43 = $20,016.43 | Interest earned: $20,000 x 1% x 30/365days =$16.43 |
| Next 30 days | Starting balance in the account: $20,016.43 Interest earned: $20,016.43 x 1% x 30/365days =$16.45 Total balance: $20,016.43 + $16.45 = $20,032.88 | Interest earned: $20,000 x 1% x 30/365days =$16.43 |
| End of 60 days | Final balance: $20,032.88 | Final balance: $20,032.86 |
The effect of compounding interest can be seen in the second month, with a slightly higher interest earned as a result of the compounding effect.
Investment returns vs. compounding interest
One common misconception, made by many finance blogs too, is using the phrase “compound interest on your investment” (Try googling it and see how many entries turn up).
Investment returns are not a result of interest.
How profit on investments is calculated:
Selling price – buying price = profits on investment
If you invest in unit trust, the profit will be calculated based on:
(Selling unit price – buying unit price) x number of units
However, the value from this formula is not exactly meaningful as it does not take into consideration the timeframe, hence “rate of return” as a measurement is more effective in judging the investment performance.
To determine the rate of return on the investment, the mathematical term is “internal rate of return” and the formula is pretty intimidating.
Source: Investinganswers.com
Hence, when we invest in the stock market, we do not earn interest. But instead, the return on the stock is based on the value of your investment. When the value of your investment goes up, that’s the return on your investment.
If you leave your money (and the returns you earn) invested in the market, those returns get compounded over time.
How do I determine the returns on my investments?
A great way to achieve your goals is to plan for them. Although investment returns are not guaranteed, you can still project an good estimate based on a return rate that you feel confident of. This will help you anticipate if your current investment strategy is sufficient to get you to your goals — or if you should make adjustments to your plan or expectations.
When calculating compound interest, the number of compounding periods makes a significant difference.
Pro tip: Check out our investment calculator to help you understand how the effect of compounding works.
Factors affecting your returns
Initial investment amount: This refers to the initial principal you place into the investment on day one.
Annual investment return rate: This refers to the projected return rate your investments could grow by.
Number of years the money is invested: Period of time you stay invested.
Annual investment amount: Additional capital you invest each year without fail. This amount is assumed to be the same.
Here’s a scenario:
I have an initial investment of $10,000 made, and at $1,000 each year over 5 years, a total of $15,000.
Assuming a 5% p.a. return rate, i’ll expect to get $18,565 at the end of 5 years — a profit of $3,565 ($18,565 – $15,000).
You can also use this Excel formula: FV(5%,5,-1000,-10000,1)
Ways to use this investment compounding calculator
1. Set a goal and work towards it
Goal: Down payment to property
Amount: $100,000
Time to goal: 8 years
You could figure out how much you need to reach your goal. If the amount of investment required to reach the goal is too high, perhaps it’s realistic to reduce the goal or take a longer time to get it.
2. Set aside money to invest and see how much it will grow
Investing part of your earnings and savings can help to beat inflation and grow your wealth. Depending on the investment instrument you choose to invest in, you can project how a different rate of returns can affect your future lump sum.
The effects of a difference between 6% and 3% with the same amount of investments over the same period is $7,065.
The effect of compounding can help you grow your wealth faster. It is also the best way to work towards your retirement goals.
Pro tip: Also check out our retirement calculator to help you work towards your retirement in a systematic and confident way.
If this was meant to educate those that are not familiar, how about telling me what p.a. is in the very first diagram.