The financial sector is one that has garnered much occupational prestige over the last few decades. While it has and can be argued that much of this prestige is misattributed, it remains one of the most difficult industries to enter and its products seem unnecessarily confusing and complex. For myself, the sheer amount of information that I had to sieve through and digest to even begin to understand the various assets was extremely daunting.
As a result, financial products have also gained a certain level of distrust from the general public, especially from the older generation. This has, of course, not been helped by stories of people losing jobs, money, homes, and even lives in recessions due to bad investments. Furthermore, with the sheer number of financial products and the ridiculously confusing names that they have, learning to invest does not always seem like it is worth the effort although it almost always is.
While there are a thousand things to talk about in finance, one of the few things that many people don’t really understand or aren’t convinced by is the power of compound interest, which I hope to rectify by providing a very basic explanation through some examples.
Why Interest is Interesting
As the generation that has grown up with more privilege that the previous, we are in a fortunate position where we can plan for retirement and are more financially literate. However, with the wealth of knowledge that we can access on our phones, one ironic problem is figuring out where to even begin learning about financial products.
Surely, most of us have heard of starting our investments early, even with small amounts as “they will eventually add up”. With some investment avenues offering as low as a $100 monthly deposit and most offering a return of less than 5%, it is not surprising to be skeptical about the value of such investments as they do not seem like they will be significant.
However, because of the nature of compound interest, I am here to tell you that there is value in putting in small amounts and planning early for the future.
Simple vs Compound Interest
Interest is the amount of money given to the owner for lending money to another. Bonds and bank accounts are examples of lending money to an institution and getting more money back while credit cards are examples of borrowing money from an institution and paying more (if payment is not made on time). Interest rates are simply the percentage of the amount lent or borrowed that will be owed. For example, borrowing $1000 at a 5% rate will yield an interest of $50.
Simple interest is, for lack of better description, simple. For example, for the recent Astrea V Private Equity bonds by Azalea with a return of 3.85% yearly, a $10000-dollar investment would yield $385 annually and holding the investment for 50 years would yield $29,250.
For those interested in doing the math, such a formula would be $10000 (principal)*0.0385 (interest)*1 (period held in years). For the others, there is this simple interest calculator.
Explaining how compound interest works is usually where people close the article or skip entirely. Hence, here is the compound interest calculator from the US’ Securities and Exchange Commission.
Using the same principal and interest rates, a $10000 investment held for 50 years would yield the following:
As one can tell, the longer an investment is held, the more powerful compound interest becomes. If one could somehow hold the above investment for 100 years, you would eventually end up with $166,122.94.
However, something that is powerful tends to be a double-edged sword and compound interest is no exception.
On the list of “good” uses, dividend reinvestment is probably one of the more practical uses that a regular person will encounter.
A dividend reinvestment program automatically reinvests any dividends into your original investment. The next year’s dividend will go through the same process and the value of an investment over a certain number of years will look similar to the table above.
Naturally, anything related to finance is rarely as easy as it sounds on paper. Some challenges a regular retail investor will face would be finding a broker that offers a reinvestment scheme and finding a stock that can provide a constant return to reap the benefits of a long-term strategy.
On the other side, one avenue where compound interest rears its ugly head against the public is through credit card debt. While it is highly unlikely that one would owe a credit card company for 5 decades, credit card debts are notorious for running people into bankruptcy and tends to carry a negative connotation among the older generation.
With an overwhelming number of credit cards to choose from that offer different benefits and have low requirements, young working adults are getting credit cards earlier than ever. While they are more financially literate than the previous generation, there are still stories of friends or families falling into the debt trap from credit cards.
Due to its high interest rates, credit card debts building up extremely quickly and is compounded (get it?) by the fact that their minimum payment per month is extremely low. In addition, credit card debt is compounded daily, which means that the effective interest rate is higher than advertised.
To illustrate the significance of daily compounding, the table below shows the amount that one would owe at the end of a year from a $10000 debt.
The above interest rate of 26.80% is taken from DBS’ Altitude card. Given our current generation’s love for travel, able to convert points into miles is undoubtedly very attractive. However, it would be prudent to be careful of the expenditure on the card lest someone ends up taking on more than they can afford to.
Hopefully, this article has made it easier to understand compound interest and has provided readers with a better understanding of how and where compound interest shows up in our lives.
If you would like to learn more about personal finance, getting started on investments, or making the right investment choices, there are multiple sharers on Kalpha that are more qualified and knowledgeable than I am to go further in depth these topics.