As I mentioned in my previous article on return on investments, we will now tackle the power of compound interest. You will see how powerful compound interest is as it is one of your allies in achieving financial freedom.
Let’s see how compound interest works by comparing simple interest vs. compound interest. You will see that it is really advantageous that you should really leave your money UNTOUCHED in the bank.
SCENARIO 1: Suppose you were able to save your first 100,000 at the age of 21. You decided to deposit it in the bank that gives a fixed 2% interest per year. You left it for 5 years.
Using the formula for simple interest where P is the principal amount, r is the interest and n is the number of years:
Interest = P multiply by r multiply by n = Prn = 100,000 (0.02) (5) = 10,000. So every year, your 100,000 earn 2,000 and after 5 years, it already earned 10,000.
Amount = P(1+rn) = 100,000 [1+(0.02)(5)] = 110,000. So your 100,000 became 110,000 after 5 years.
Using the formula for compound interest where ^ denotes exponent:
Amount = P[(1+r)^ n] = 100,000 [(1+0.02)^5] = 110,408.08. So your 100,000 became 110,408.08 after 5 years.
That means you have an extra interest of 408 as against the 110,000 earned using the simple interest. How did this happen? It is because your principal changes every year, as the interest earned every year now becomes part of the principal. To illustrate this, let’s see the computation below on the interests and principal amounts:
1st year interest = 100,000 (0.02) = 2,000. Add this interest to the original 100,000 principal, the new principal becomes 102,000.
2nd year interest = 102,000 (0.02) = 2040. Add this interest to the 102,000 principal, the new principal becomes 104,040.
3rd year interest = 104,040 (0.02) = 2,080.80. Add this interest to the 104,040 principal, the new principal becomes 106,120.80.
4th year interest = 106,120.80 (0.02) = 2,122.416. Add this interest to the 106,120.80 principal, the new principal becomes 108,243.22.
5th year interest = 108,243.22 (0.02) = 2,164.8644. Add this interest to the 108,243.22 principal, the new principal becomes 110,408.08.
Let’s see an example of frugal person leaving below his means, equipped with the right knowledge in investments and he regularly saves money.
SCENARIO 2: Suppose Charles is a frugal single person, age 21, living with his parents, and because of his employment and other sideline jobs, he was able to save 200,000 per year. He is equipped with the right knowledge in financial literacy and he was able to find a well performing fund that guarantees at least 10% fixed interest per year and he invested his money into it. How many years will it take him to be a millionaire?
Let’s see how powerful compound interest in this scenario given that he’s adding 200,000 each year to the principal.
1st year: 200,000 [1+0.10] = 220,000.
2nd year: 220,000 [1+0.10] + 200,000 = 442,000.
3rd year: 442,000 [1+0.10] + 200,000 = 686,200.
4th year: 686,200 [1+0.10] + 200,000 = 954,820.
5th year: 954,820 [1+0.10] + 200,000 = 1,250,302.
So Charles is a millionaire even BEFORE the end of 5th year at the age of 26. What if the fund earned 12%? 15%? 20%? He can definitely achieved a million in less than 5 years.
So imagine, if you equipped yourself with the right knowledge in financial literacy and you are regularly saving as a result of your frugal living, the power of compound interest will help you as you build your pile of assets eventually achieving financial freedom as time passes.
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