You have probably seen or heard people discussing the power of compound interest. If you haven’t, then this post is for you. We need to look at the practicality and power of compound interest and leverage such financial opportunities as much as we can, while we can.
Discussing money can be addictive. Investing is like a well-thought-out game, where those who are risk-averse and dare to diversify their investments in the right places are likely to learn the rules quickly and succeed eventually.
When a financial institution is offering a particular investment and talking about say 10% per annum interest, then there are two options. Institutions may calculate the interest on the initial deposit alone, otherwise known as simple interest. Then, we have the magical compound interest.
Compound interest (or compounding interest) is the interest on a deposit calculated based on both the initial principal and the accumulated interest. So, simply put, the power of compound interest is the fact that your interest earns you more interest. The higher your interest, the more the money grows.
With compound interest, you earn from the original principal plus accumulated interest. This, enough, is an incentive to put your money in compound interest investments because even with the smallest initial investment, it’s almost impossible to lose out.
Let’s say you invest in a company offering 10% interest, compounded monthly. You choose to put in 5,000 Kenya shillings. At the end of the first month, you have 5,500 shillings. With compound interest, the 5,500 shillings becomes the new ‘initial capital.’ Therefore after another month, you have 6,050 shillings which is 110% of 5,500 shillings.
What would you look out for when investing in such businesses? Among the most important factors is to find one whose interest rate is higher than the inflation rate in your country. For example, currently the Annual Average Inflation in Kenya, according to Central Bank, is 5.20%. When you’re looking for a compound interest investment, find one whose percentage is higher than this.
Compound interest causes your wealth to grow faster. When competing with the inflation rate and your interest is earning more interest, your initial investment can earn you much much more than many alternative investments forms. It is key to helping mitigate wealth-eroding factors like the rising cost of living, inflation, and reduction of purchasing power.
Compound interest is calculated by multiplying the initial principal amount by one, plus the annual interest rate raised to the number of compound periods, minus one. When calculating compound interest, the number of compounding periods makes a significant difference. The higher the number of compounding periods, the greater the compound interest.
What I have come to learn, when it comes to investing, is that you need to the groundwork yourself. You have to set aside time to research and find the investment opportunities that work for you. You have to read policies and clauses before committing to investments, lest you get shocked a few years to come. What works for one person may not work for the other. Before you copy someone and start playing the blame game, research for yourself.
With that said, there are various investments that you can look into that offer compound interest. This includes money market funds, bonds, stocks, treasury securities, and real estate investment trusts.
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” ~Albert Einstein