Updated: 12th October 2018
Make your money work for you by taking advantage of the power of compound interest. Not quite sure what it involves? Learn what compound interest is and how you can (theoretically) make your first million with it!
What is compound interest?
Compound interest is interest that is added to the principal amount. With compound interest, you will be earning interest on top of the interest you have already earned. The addition of interest to the principal amount is known as compounding.
Most people tend to overlook the power of compound interest, but that is perhaps because they don’t quite understand how it works. Here’s how it works:
For example, if you put RM10,000 in a fixed deposit account with a 7% annual interest for 2 years, most would thing that you will end up with RM11,400 right? Not quite.
You would actually have RM11,449. Because with compounding interests, the first year you will earn 7% interest on RM10,000, and in the second year, you will earn 7% interest on RM10,700. Compounding interest is basically interest on interest; you are earning interest on top of the first year’s interest which was RM700.
The basic principle of compound interest is earning additional interest on top of previously earned interest. Which means once you earn your first interest payment, it will then be added to the principle, and that is how you can make your money work for you by utilizing compound interest!
Why should you take advantage of compound interest?
When you harness the power of compounding, it can greatly impact the amount of savings you can accumulate over the long term simply by utilizing time and the increasing amount of your savings. However, compounding interests will only have a a dramatic impact on your savings provided you are disciplined by not withdrawing the money early.
If you start saving earlier, it also means there will be more years of compounding interest, meaning that you can gain a greater return of investment even with a lower total investment amount at the start. This is especially helpful for people saving their money through an investment vehicle over a long period, such as saving for retirement.
How you can make a million Ringgit with compound interests?*
In this theoretical million ringgit test, let’s start you by setting aside RM10,000 in an account with an annual interest of 7%. Following that deposit of RM10,000, the table below shows how much money you will have to invest in order to reach a million Ringgit by the time you turn 65.
*calculation done by using Compound Interest Calculator.
Note: If you would like to project the amount of money you can have with compound interest, you can do so by using this calculator.
In order to take the full advantage of compound interest, you should take note that it works best when you have a larger starting amount with a lot of time to reap from it. When you have both time and reasonable amount to set aside, the gains from compound interest can be exponential with time. If you are starting 10 years earlier, you can make 63% more money, as illustrated in the table below. The early bird gets the worm!
it is very important that you get started as early as possible and compound interest can work better in your favour. However, if your goal is to have a million Ringgit in your account in time for your retirement, starting early with at least RM10,000 is ideal as illustrated in the table above.
Provided you are willing to take on more risk, you can get a higher interest rate for your money. This will translate to a more dramatic growth for your money with compounding interest as illustrated in the table below.
Do take note of the key factors that determine how successfully compound interest will work for you: Factors like time, the initial amount you invest, and amount of interest. As seen in the table above, the amount of interest rate will also play a big role into how much returns you will get.
*Method to achieve the million Ringgit mark is only theoretical and helps to demonstrate the power of compounding interests only.