< BACK TO EDUCATIONAL ARTICLES

Using Compound Interest as a Savings Plan

pexels-lukas-590020

Using Compound Interest as a Savings Plan

  • One of the most important concepts to understand when managing your finances, compound interest can help you earn a higher return on your savings and investments over the long term.
  • Compound interest is interest earned on money that was previously earned as interest, in addition to the initial principal and it is an excellent way of growing your money.
  • An important element when it comes to calculating the compound interest is the number of compounding periods, meaning the frequency by which the accumulated interest is paid out or capitalised. This could be yearly, half yearly, quarterly or monthly.
  • Time is a major factor when it comes to harnessing compound interest’s power. This is why the earlier you begin compounding your money, the more dramatic the results.
  • Making regular deposits or allowing your money to grow without withdrawing any money will allow you to truly benefit from compound interest.
  • The interest rate plays a crucial role and is an important factor in your account balance over time. The higher the rate, the faster your account will grow.
  • Yet, one factor that will not affect compounding is the starting amount so do not be too discouraged if you can only afford to start off with just a few euros.

 

Whether it is the interest on your home loan or the yields on your various investments, interest rates play a crucial role when it comes to your money. And while we often associate these with their ability to drain our bank account most especially when it comes to loans, one type of interest – compound interest – can help you earn a higher return on your savings and investments.

One of the most important concepts to understand when managing your finances and the basis of everything ranging from your personal savings plan to the long-term growth of the stock market, compound interest can significantly boost investment returns over the long term, so the sooner you start to save, the more you will earn.

Here we analyse the power of compounding and how it can help you grow your savings.

 

pexels-bongkarn-thanyakij-3787798

 

What is compound interest and how does it work?

The first thing that may cross your mind when thinking of interest is debt, however, interest can at times work to your favour, most especially when this is earned on the money you have either saved or invested. As a result, compound interest is interest earned on money that was previously earned as interest, in addition to the initial principal. Think of it as a cycle of earning interest on interest and it is an excellent process of growing your money, so much so that it will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated on the principal amount alone. In this manner, your balance does not just grow, but it does so at an increasing rate, marking what is known as exponential growth. 

An important element when it comes to calculating the compound interest is the number of compounding periods which makes a significant difference. The frequency by which the accumulated interest is paid out or capitalised could be yearly, half yearly, quarterly or monthly, while at times it may also be dailyAs a general rule, the higher the number of compounding periods, the greater the amount of compound interest. 

Compound interest’s formula is calculated by multiplying the initial principal amount by one, plus the annual interest rate raised to the number of compound periods minus one. An easy way of calculating this is to use our Compound Interest Calculator and give various scenarios a go.

 

What makes compound interest so powerful?

As stated above, compounding takes place when interest is paid repeatedly, this is why the frequency of compounding is so crucial. However, there are other factors: 

  • Time: in order for you to truly recognise compound interest’s power, it must take place over long periods of time, so the earlier you begin compounding your money, the more dramatic the results.
  • Deposits: your funds will not increase if you withdraw often. An investment left untouched for a number of decades can add up to a large sum even if you never invest another euro.
  • Interest rate:  the interest rate plays a crucial role and is an important factor in your account balance over time. The higher the rate, the faster your account will grow.
  • Starting amount: the initial amount you start off with will not affect compounding. This is why when you start saving outweighs how much you can save. 

 

pexels-lukas-590041

 

A real-life example

You can make the most of compound interest if, for instance, you invest in a Bond or an Income Fund that allows an investor to accumulate interest year on year.
Let us take investing in a Bond as an example:

An investor invests €10,000 in a bond that pays 7% interest per annum. The Bond would pay interest of € 700 on the first year, therefore the balance would be €10,700 at the end of the first year.

On the second year the interest of 7% would be calculated on € 10,700 and therefore the interest received would be €749. In year two the investor does not need to add anything to his savings, although he may choose to do so to increase the multiplier effect.

On the third year the interest of 7% would be calculated on €11,449 (€10,700 + €749) and so the interest received would be €801.43. This process would continue until the Bond is either redeemed or is sold. In this example an investor would almost double his money in 10 years without adding any extra capital.

For a clearer picture of the above example, have a look at the table below:

Year Interest for the year Total accumulated interest Balance
0 0 0 € 10,000
1 € 700.00 € 700 € 10,700
2 € 749.00 € 1,449.00 € 11,449.00
3 € 801.43 € 2,250.43 € 12,250.43
4 € 857.53 € 3,107.96 € 13,107.96
5 € 917.56 € 4025.52 € 14,025.52
6 € 981.79 € 5,007.30 € 15,007.30
7 € 1,050.51 € 6057.81 € 16,057.81
8 € 1,124.05 € 7,181.86 € 17,181.86
9 € 1,202.73 € 8384.59 € 18,834.59
10 € 1,286.92 € 9,671.51 € 19,671.51

How can compound interest grow your savings?

Let’s consider two investors:

Investor A
Starting from the age of 25, Investor A puts € 2,000 per year into fixed income, like Bonds or an Income Accumulator Fund for 10 years until he is 35. At 35, he stops and does not put any more money into his investment portfolio and lets his investment work alone. Investor A then leaves his investments to grow until he hits age 65. He earns an average annual return of 8% and when he looks at his account 30 years later, he has €314,870.

Investor B
Investor B does not save anything until he is 35, at which age he starts investing €2,000 per year. He keeps this up for the next 30 years until he reaches 65. Investor B earns an average annual return of 8% too but he ends up with € 244,691 at the age of 65.

As a result:

  • Investor A has invested a total of € 20,000 and ended up with € 314,870.
  • Investor B has invested a total of € 60,000 and ended up with € 244,691.

This means that Investor A is now worth 28% more than the Investor B even though Investor A only invested a third of the amount.

 

pexels-jopwell-2422293

 

How to make the most of compound interest

There are other elements to consider if you want to ensure that compounding works to your advantage.

Pay off your debts as soon as possible: if you have credit card debt, paying the bare minimum can cost you since you will hardly be making a dent in the interest charges, while in actual fact your balance could grow. So pay off debts as quickly as possible and if you can, pay extra.
Watch out for the annual percentage yield (APY): the APY is the real rate of return earned on a savings deposit or an investment and it’s important to look into this since it takes into account the effect of compounding and can provide a true annual rate.

Starting to set something aside at an early age will give your investments time to grow and produce a compound interest multiplier effect that will help you in the later years. One of Malta’s largest independent financial services group and a founding member of the Malta Stock Exchange, CC pioneered the local financial services industry in 1972. Since then the Group has established itself as a 360-degree financial planner for investments, pensions and life insurance, while it offers a range of investment products that can help you make the most of compound interest. Get in touch with one of our financial advisors today to get started.