MANILA, Philippines - Nobel Prize winner and renowned physicist Albert Einstein is widely rumored to have once said that the most powerful force in the universe is compound interest. He is credited with discovering the compound interest rule of 72, and was quoted as saying: "It is the greatest mathematical discovery of all time."
Depending on the source, Einstein referred to compound interest as the eighth wonder of the world, the human race's greatest invention, or the most powerful force of the universe.
Have we convinced you yet? The compound interest is not too complicated to understand — you don’t need to have Einstein’s IQ. It is simply interest earning interest. Its impact on your money, though, may be a bit more difficult to appreciate so we’ll try and explain a little bit more.
Compounded interest allows you to earn more on your investment than simple interest. How does the compound interest work? To compute for simple interest, you simply take the interest rate on the principal. Say you have P100,000 earning 5% interest per year. After ten years, you would have made P50,000 in interest. With compound interest, the interest rate applies on the principal amount and any interest it may have earned after a specific period. Therefore, an investment amount of P 100,000 earning 5% interest compounded yearly would give you earnings of P62,889 over the same ten year period. Imagine, then, if you started investing early on. To illustrate, money growing at 6 percent per year will double in about 12 years, and will be worth four times as much in 24 years.
Another example of how compound interest works are insurance plans that self-liquidate after a certain time period. The plan pays off after you have made some payments because accumulated dividends are left to compound. Eventually, the amount is enough to cover your yearly premium payments.
Compounding also works its magic on sinking funds. If you were to save P500 per month earning 5 percent interest compounded each month continually for 10 years, you would have P77, 600 from your savings of P60,000. If you stop putting in money on the tenth year, the funds would still grow to over P150,000 after another 15 years.
Over the long term, compounding is a tool you can use against inflation, which erodes the value of your money. This will, of course, depend on the instrument that you put your money in, and the level of inflation.
Most investment products will earn compound interest if the earnings are reinvested in the account. This includes deposit accounts and short term and long term investment instruments (money market funds, mutual funds, UITFs) which are readily available to retail investors through various channels including the branch networks of banks.
Compounding of interest is done in many instances. You may also encounter compounded interest with your credit card payments. Most credit cards charge a monthly interest fee if you do not pay for your bill in full. Your outstanding balance then gets rolled over to the next billing statement, and will be charged the monthly interest.
If you rolled over P1,000 and your credit card charges a monthly interest rate of 3%, then you would owe P1,030 in your next billing statement.
If you make a purchase of P10,000, then you would have to pay a 3% interest on the P1,030 and the P10,000 combined.
If, on the next billing cycle, you do not pay in full, the balance and any additional purchases you make will again be charged the monthly interest rate.
This is why you should be mindful of how compound interest rates affect your portfolio. Just as they can enhance your savings, so can they increase your debt. Therefore, it is important to understand how they work.
How can you begin to make compound interest work for you?
- First, find the right product in relation to your financial goals. Everything you do should be part of a larger financial plan. Determine what you want to achieve, your time frame, the amount of your investible funds, and the level of risk you are willing to take on. This will guide you in choosing the types of instruments to invest in.
- Then, find a product that compounds as frequently as possible. You will earn more if your savings compound monthly rather than quarterly, for obvious reasons. Find investment funds that will do this for you.
- Choose the products with higher interest as they will compound faster than one with a lower interest rate. Note, however, that products with higher interest rates carry more risk than those with lower interest rates. Some savings accounts may offer very low interest rates, so consider mutual funds or other money market instruments with better rates while taking your risk profile and financial goals into consideration.
- Time is an important factor in compound interest. To make compounding truly work for you, you would need a long time frame to work with. The longer your money compounds, the faster it will grow. This is why you are encouraged to invest in your retirement or pension funds from an early age. An individual who puts money into his retirement fund at age 30 will definitely stand to gain more than the person who begins to put funds into this account at age 50.
- Before you sign on the dotted line, ask about terms. Prior to purchasing any investment product or putting money into a deposit instrument, ask how often the interest compounds, and what steps you may have to do. Some instruments may require your explicit instructions for the amount to be rolled over.
Goodluck and three cheers to compound interest (and Einstein, of course)!
Grow Your Money is an editorial partnership between ABS-CBNnews.com and Citi Philippines to promote financial education and provide helpful information to Filipinos on how to better manage their personal finances.
Visit www.citibank.com.ph for more information.